INTERNATIONAL FISHER EFFECT: A REEXAMINATION WITHIN THE CO-INTEGRATION AND DSUR FRAMEWORKS

INTERNATIONAL FISHER EFFECT: A REEXAMINATION WITHIN THE CO-INTEGRATION AND DSUR FRAMEWORKS A THESIS SUBMITTED TO THE GRADUATE SCHOOL OF SOCIAL SCIENCES OF MIDDLE EAST TECHNICAL UNIVERSITY BY EDA ERSAN IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF BUSINESS ADMINISTRATION IN THE DEPARTMENT OF BUSINESS ADMINISTRATION DECEMBER 2008

Approval of he Graduae School of Social Sciences Prof. Dr. Sencer Ayaa Direcor I cerify ha his hesis saisfies all he requiremens as a hesis for he degree of Maser of Business Adminisraion.. Prof. Dr. Cengiz Erol Head of Deparmen This is o cerify ha we have read his hesis and ha in our opinion i is fully adequae, in scope and qualiy, as a hesis for he degree of Maser of Business Adminisraion. Examining Commiee Members Assis. Prof. Dr. Seza Danışoğlu Supervisor Assoc. Prof. Dr. Nuray Güner (METU, BA) Assis. Prof. Dr. Seza Danışoğlu (METU, BA) Assoc. Prof. Dr. Burak Günalp (Haceepe., ECON)

I hereby declare ha all informaion in his documen has been obained and presened in accordance wih academic rules and ehical conduc. I also declare ha, as required by hese rules and conduc, I have fully cied and referenced all maerial and resuls ha are no original o his work. Name, Las name : Eda ERSAN Signaure : iii

ABSTRACT INTERNATIONAL FISHER EFFECT: A REEXAMINATION WITHIN THE CO-INTEGRATION AND DSUR FRAMEWORKS Ersan, Eda MBA, Deparmen of Business Adminisraion Supervisor: Assisan Prof. Dr. Seza Danışoğlu December 2008, 68 pages Inernaional Fisher Effec (IFE) is a heory in inernaional finance which assers ha he spo exchange rae beween counries should move in opposie direcion wih he ineres rae differenial beween hese counries. The aim of his hesis is o analyze wheher differences in nominal ineres raes beween counries and he movemen of spo exchange raes beween heir currencies end o move ogeher over he long run. The presence of IFE is esed among he G-5 counries and Turkey for he period from 1985:1 o 2007:12. The long run relaionship is esimaed wih he Johansen co-inegraion mehod and supporive evidence is found for all counry pairs. Individually modeled equaions are furher esed wih he Dynamic SUR mehod. Those DSUR equaions ha include he Turkish currency provide supporive evidence for IFE ha higher ineres raes in favor of Turkey would cause depreciaion of he Turkish Lira. The magniude of he effec is found o be lower han expeced which indicaes ha here migh be oher facors in economy, such as inflaion raes, ha affec he exchange rae movemens. Key Words: Inernaional Fisher Effec (IFE), Dynamic Seemingly Unrelaed Regressions (DSUR), Co-inegraion, Uncovered Ineres Rae Pariy (UIP). iv

ÖZ ULUSLARARASI FISHER ETKISI: EŞBÜTÜNLEME VE DİNAMİK GÖRÜNÜŞTE İLİŞKİSİZ REGRESYON YÖNTEMLERİ DAHİLİNDE YENİDEN İNCELEME Ersan, Eda Yüksek Lisans, İşleme Bölümü Tez Yöneicisi: Yrd. Doç. Dr. Seza Danışoğlu Aralık 2008, 68 sayfa Uluslararası Fisher Ekisi (UFE), ülkeler arasındaki geçerli kurun bu ülkeler arasındaki faiz oranı diferansiyeliyle zı yönde hareke emesi gerekiğini savunan bir uluslararası finans eorisidir. Bu ezin amacı, ülkeler arasındaki nominal faiz oranlarındaki farklılıkların ve bu ülkelerin para birimleri arasındaki geçerli kur harekeinin uzun dönemde birlike hareke eme eğiliminde olup olmadığının analiz edilmesidir. UFE nin varlığı 1985:1-2007:12 dönemleri arasında G-5 ülkelerinde ve Türkiye de es edilmişir. Johansen eşbüünleme yönemi ile uzun dönem ilişki ahmin edilmiş ve üm ülke çifleri için desekleyici kanı bulunmuşur. Buna ilave olarak, ayrı ayrı modellenmiş denklemler, Dinamik Görünüşe İlişkisiz Regresyon (DGİR) yönemiyle es edilmişir. Türk para birimini içeren DGİR denklemleri, Türkiye lehine yüksek faiz oranlarının Türk Lirası nda değer kaybına yol açacağına yönelik, UFE ni desekleyici, kanı sunmuşur. Bu ekinin şiddei beklendiğinden daha küçük olmuş ve bu da ekonomide kur harekelerini ekileyen, enflasyon oranı gibi, başka fakörlerin de olabileceğini gösermişir. Anahar Kelimeler: Uluslararası Fisher Ekisi, Dinamik Görünüşe İlişkisiz Regresyon, Eşbüünleme, Karşılanmamış Faiz Pariesi v

To My Dear Moher and Grandmoher vi

ACKNOWLEDGMENTS This sudy is accomplished wih precious conribuions of many people whom I am very pleased o hank for sharing boh joy and sorrows of compleion of his hesis. I would like o hank my hesis supervisor Assis. Prof. Seza Danışoğlu for her guidance, assisance, advises and criicisms during he long and difficul phases I faced o complee his sudy. Also I would like o express my graefulness o oher members of he examining commiee, Assoc. Prof. Dr. Z. Nuray Güner and Assoc. Prof. Dr. Burak Günalp and for heir valuable commens and suggesions. I owe a hank o my insrucors a Bilken Universiy, especially o Prof. Dr. Hakan Berumen for igniing and encouraging my ineres in macro economy and for eaching me he fundamenals of economerical analysis. I would like o appreciae he olerance of my colleagues a Deloie, during difficul and long working hours ha we worked ogeher on field assignmens. I am graeful o my dear friends Mine and Serkan for heir psychological suppor during he hard imes I faced for he compleion of my hesis. I would like o hank hem for moivaing and supporing me during his period. And finally I wish o express my deepes graiude o my beloved family for heir paience, endless suppor and for heir belief in me. Wihou heir encouragemens his hesis would no have been compleed. vii

TABLE OF CONTENTS PLAGIARISM... iii ABSTRACT... iv ÖZ... v ACKNOWLEDGMENTS... vii TABLE OF CONTENTS... viii CHAPTER 1. INTRODUCTION... 1 2. LITERATURE REVIEW... 4 2.1 Inroducion... 4 2.2 The Fisher Hypohesis and Fisher s Findings... 5 2.3 The Theory of Purchasing Power Pariy... 9 2.4 The Inernaional Fisher Effec Hypohesis... 12 2.5 Conclusion... 22 3. DATA AND RESEARCH METHODOLOGY... 25 3.1 Inroducion... 25 3.2 Daa... 26 3.2.1 Exchange Rae Daa... 26 3.2.2 Ineres Rae Daa... 26 3.2.3 The Sample Period... 27 viii

3.3 The Research Mehodology... 29 3.3.1 Uni Roo Tess... 30 3.3.1.1 Augmened Dickey-Fuller Tes... 31 3.3.1.2 Kwiaowski Phillips Schmid Shin Tes... 33 3.3.2 Co-inegraion Tess... 34 3.3.3 Panel Uni Roo Tess... 36 3.3.4 The DSUR Esimaion... 37 3.4 Summary... 42 4. RESULTS AND ANALYSIS... 44 4.1 Inroducion... 44 4.2 Uni Roo Tes Resuls... 44 4.3 Johansen Co-inegraion Resuls... 49 4.4 Panel Uni Roo Resuls... 52 4.5 DSUR Resuls... 54 5. CONCLUSION... 62 BIBLIOGRAPHY... 66 ix

CHAPTER 1 INTRODUCTION Invesmen is he commercial way of using money wih an aim o obain profi in reurn. A crucial poin for invesors is predicing he forhcoming reurns of heir invesmen. Invesors usually have o compare differen invesmens on he basis of heir risks and reurn poenial in order o make a choice from among differen alernaives. When he decision is abou an inernaional invesmen opporuniy, he comparison of invesmen reurns becomes a lo more complicaed. In addiion o he risk and reurn comparisons, he invesors also have o ake ino accoun he poenial changes ha hey expec o occur in he exchange rae beween he foreign currency and he domesic currency. In such a case, heories regarding he deerminaion and ineracion of ineres and exchange raes come ino he picure. Many economic heories have been developed o analyze how macroeconomic variables like ineres and exchange raes move hrough ime when exerior inervenions o financial markes are minimized. These heories simply reveal ha he ineracions beween inernaional markes should be analyzed carefully concerning he expeced responses of such macroeconomic variables. One of hese heories is derived from he well-known Fisher Effec, which assers real ineres raes across counries are equalized when nominal ineres rae differences are driven by he discrepancies in inflaion raes across counries. In oher words, according o he Generalized Fisher Effec, high inflaion counries should bear higher ineres raes, if perfec inegraion of capial markes is achieved by financial markes. When he main quesion is he inernaional equilibriums, in addiion o ineres raes and inflaion raes, movemens of exchange raes are also 1

imporan. Many heories have been developed o explain he changes in exchange raes. The Purchasing Power Pariy condiion is one of hese heories. The heory implies ha he exchange raes will move o offse changes in inflaion rae differenials. The raionale behind his pariy heory is he equaliy of prices across counries. Anoher inernaional marke equilibrium condiion is he Inernaional Fisher Effec, which can be defined as a combinaion of he Generalized Fisher Effec and he Purchasing Power Pariy. Briefly, he heory assers ha he higher ineres rae counry s currency is expeced o depreciae unil he real reurns of invesmens are equalized across counries. The aim of his hesis is o analyze he responses of exchange raes o he differences in ineres raes across counries. In an open marke, changes in exchange raes will affec he fuure value of curren invesmens. Therefore, his analysis is imporan for invesors, as hey are concerned abou fuure earnings while making decisions abou invesmens oday. Theoreically, in order o analyze he relaionship beween ineres raes and exchange raes, pariy condiions are developed in he inernaional finance lieraure. In line wih he heory, his hesis evaluaes he relaionship beween exchange raes and ineres raes of six seleced counries, namely he G-5 counries and Turkey. The heory is evaluaed wih seleced counries for he period saring from January, 1985 and ending wih December, 2007. I is expeced o find empirical resuls in favor of he Inernaional Fisher Effec so ha he higher/lower ineres rae counry s currency is expeced o depreciae/appreciae in order o equalize ineres raes across counries. Since he financial daa used are no saionary, he radiional regression models are no appropriae o es his relaionship. Insead, he relaionship beween ineres rae differenials and changes in exchange raes is analyzed wihin he co-inegraion framework. The Johansen co-inegraion mehod is applied o he daa and a leas one co-inegraion vecor is found for each of he couny pair, which is a resul indicaing ha ineres rae differenials and exchange rae movemens drif ogeher in he long-run. 2

Economeric analysis in his hesis aims o examine he effeciveness of inernaional markes o respond o he capial flows and he relaionship beween macroeconomic variables of developed counries among hemselves and heir ineracion wih he Turkish financial markes. The main reason for selecing he G- 5 counries is he inegraion of he capial markes in hese counries. In general, he capial markes of developed counries are acceped o be inegraed so ha he basis for inernaional pariy condiions is esablished. In addiion, governmens in developed counries are less likely o inervene in financial markes. Currency resricions and oher governmenal inervenions affec he adjusmen of exchange raes over ime and inhibi capial inegraion. Therefore, esing for he exisence of pariy condiions has o be carried ou in markes where such marke imperfecions are deemed o be a a minimum. The following chaper reviews he lieraure and explains he underlying heories abou he relaionship beween exchange rae adjusmens and ineres rae differenials. In Chaper 3, he daa used for he analyses and he research mehodology used o es he relaionship beween exchange rae movemens and ineres rae differenials are described. In addiion, he daa periods and formaion of subperiods are explained. In Chaper 4, he resuls and analyses are presened. EVIEWS oupus are rearranged in ables and resuls obained from he ess are inerpreed. Finally, he main findings of he research and implicaions for furher sudies are summarized in Chaper 5. 3

CHAPTER 2 LITERATURE REVIEW 2.1 Inroducion The main purpose of his hesis is o es wheher he Inernaional Fisher Effec (IFE) holds among he six sample counries ineres and exchange raes. The IFE is one of he ineres rae pariy condiions. There are wo versions of he heory which are defined as he covered and uncovered ineres pariy (UIP) condiions. The uncovered ineres rae pariy heory suggess ha risk-neural invesors are indifferen beween foreign and domesic asses, assuming ransacions coss are ignored wih perfec capial mobiliy and no inervenion of moneary auhoriies. The covered ineres rae pariy claims ha he difference beween he forward and spo exchange raes will reflec he differences beween he ineres raes beween wo counries. The main quesion of his hesis is o examine wheher he ineres rae differenials are unbiased predicors of fuure spo exchange raes or no. Since boh heories analyze he relaionship beween ineres raes and exchange raes, he IFE and UIP lieraure is reviewed ogeher in secion 2.4. In order o explain he IFE hypohesis more precisely, wo building block heories, namely he Fisher Effec (FE) and he Purchasing Power Pariy (PPP) are firs discussed in Secions 2.2 and 2.3, respecively. 4

2.2 The Fisher Hypohesis and Fisher s Findings The Fisher hypohesis, which was firs proposed by Irving Fisher, suggess ha here is a posiive correlaion beween nominal ineres raes and expeced inflaion. This hypohesis also implies ha he real ineres rae is consan and independen of moneary measures. In a world of perfec foresigh, he Fisher effec can be defined as a one-o-one relaionship beween nominal ineres raes and expeced inflaion, leaving real ineres raes independen of he inflaion rae. The basic version of he equaion ha has been used o es he exisence of he Fisher effec is as follows: i = α + βπ (1) e In his equaion, i is he nominal ineres rae, α is he real ineres rae and e π is he expeced inflaion for he period. By definiion, β is expeced o be equal o 1 in order o conclude for a srong Fisher effec. If β is posiive bu no equal o one, hen here is evidence of he weaker form of he Fisher effec. Fisher (1930) employed a disribued lag srucure by using annual consumer price index (CPI) daa beween he years 1890 and 1927 in he US marke and 1820 and 1924 in he UK marke. He used he arihmeically declining weighs mehod and 20 years of lags for price changes in he US and 28 years of lags for he UK. He esed Equaion (1) and reached he following conclusion: (1930, p 451) When he effecs of price changes upon ineres raes are disribued over several years, we have found remarkably high coefficiens of correlaion, hus indicaing ha ineres raes follow price changes closely in degree, hough disanly in ime. Fisher s sudy provides srong evidence abou he one-o-one posiive relaionship beween nominal ineres raes and expeced inflaion which leaves he real ineres 5

raes consan over ime. This conclusion is known as he Fisher hypohesis/effec and has been debaed for several years in he lieraure. In his sudy, Fama (1975) quesions he Fisher hypohesis by using raional expecaions assumpions while poining ou he characerisics of an efficien marke which uses all relevan informaion in seing prices. According o Fama, in an efficien marke, if he inflaion rae is o some exen predicable, here will be a relaionship beween nominal ineres rae observed a a poin of ime and rae of inflaion subsequenly observed. In order o es his asserion, he ess he efficiency of he US Treasury bill (T-bill) marke by using 1- o 6-monh mauriy T-bills and he CPI during he poswar period beween January 1953 and July 1971. Resuls sugges he exisence of a definie relaionship beween nominal ineres raes and rae of inflaion. During he sample period, he nominal ineres raes summarize all he informaion abou fuure inflaion raes. This observaion leads o he conclusion ha he T-bill marke seems o be efficien in he sense ha shor erm ineres raes are good predicors of inflaion. Anoher major conclusion of he paper is ha during his period, equilibrium expeced real reurns on T-bills are found o be consan. As a resul of hese findings, Fama concludes ha he US T- bill marke is efficien in seing 1- o 6-monh nominal ineres raes. In oher words, he marke correcly uses all informaion conained in he ime series of pas inflaion raes o form expecaions for fuure inflaion raes. The Fisher hypohesis has been sudied for many differen ime periods and conradicory resuls are reached in differen sudies. The Fisher effec has been found o be srong in some counries, for insance in US, Canada and UK, during he poswar period unil he lae 1970s. However, he same consisen relaionship beween ineres raes and expeced inflaion is no observed in oher counries. Hence, several sudies have aemped o examine he reason behind why Fisher effec holds for some counries while i does no for ohers. Mishkin (1992) analyzes he reason for obaining differen resuls over differen sample periods. He uses monhly daa on inflaion raes calculaed from CPI series 6

and 1- o 12-monh US T-bill raes during he poswar period beween February 1964 and December 1986. The analysis provides no evidence for a shor run Fisher effec during he poswar period. However, he exisence of a long run Fisher effec implies ha when inflaion exhibis rends, here will be a srong correlaion beween inflaion and ineres raes. Therefore, he Fisher effec appears o be srong during he periods when ineres and inflaion raes boh exhibi rends and he concludes ha he Fisher effec is due o he exisence of a sochasic rend beween ineres raes and inflaion. Mishkin also shows ha beween 1979 and 1982 period and during he pre-world War II period, no Fisher Effec is observed in he US daa due o he nonexisence of his sochasic rend. Hence, he evidence in he Mishkin sudy suggess ha he validiy of he Fisher effec depends heavily on he period considered and ha he Fisher effec is mos apparen in periods when here is srong evidence for sochasic rends. Oher sudies in he lieraure also sugges ha counry selecion is anoher criical facor in he empirical esing of he Fisher effec. One of he recen muli-counry Fisher effec sudies is done by Berumen and Jelassi (2002). In his sudy, Berumen and Jelassi es he exisence of a long run Fisher effec by aking ino consideraion he shor-run dynamics of he ineres raes for 12 developed and 14 developing counries. Treasury bill raes from hese counries are used for he ess. Whenever T-bill raes are no available, he lending rae is used insead. The auhors use monhly daa in order o avoid he aggregaion bias problem which can occur wih annual daa. The inflaion rae is measured by he logarihmic firs difference of he CPI. The srong form of he Fisher hypohesis is examined and i is concluded ha he shor-run responses of he nominal ineres rae o expeced inflaion do no display a consisen paern. For some developing counries, he shor erm adjusmen of he nominal ineres rae o expeced inflaion is more han proporional. In conras, for developed counries, he shor run adjusmen of he nominal rae o expeced inflaion is always less han proporional. The empirical resuls sugges a poin-for-poin relaionship beween nominal ineres raes and expeced inflaion for 16 ou of 26 counries and he conclusion of he exisence of he Fisher hypohesis holds more for developed counries han developing ones. 7

The Fisher effec is a hypohesis for domesic ineres raes. An exended version of his hypohesis is he Generalized Fisher Effec (GFE) which considers he ineracions beween counries and saes ha real reurns are equalized across counries hrough arbirage. Wihin he conex of he GFE, he nominal ineres rae differenial beween wo counries is equal o heir anicipaed inflaion differenial. i = π π (2) h i f e h e f In Equaion (2), i h and i are home and foreign nominal ineres raes, respecively, f and π π denoes he anicipaed inflaion differenial beween he wo e h e f counries. The heory suggess ha he higher inflaion rae counry should bear higher ineres raes relaive o he lower ineres rae counry so ha, in he absence of governmen inervenion, capial flows owards he higher expeced reurn counry unil expeced real reurns are equalized. Capial marke inegraion is an imporan condiion for he GFE since here should no be any resricions on capial mobiliy so ha capial is can flow freely across borders. In he lieraure, mos empirical sudies concerning he GFE have primarily focused on developed counries. Mos of hese sudies find evidence ha does no suppor he exisence of a GFE. However, some sudies are able o presen supporive resuls when he GFE is analyzed over longer ime periods. The sudy by Al- Khazali and Osamah (2004) es for he exisence of he GFE by looking a he relaionship beween inflaion and common sock reurns in nine Asian counries: Ausralia, Hong Kong, Indonesia, Japan, Souh Korea, Malaysia, he Philippines, Taiwan, and Thailand. They use monhly shor-erm ineres raes (Treasury bill raes or deposi raes) and monhly changes in he CPI as proxies for expeced inflaion in he individual counries beween January 1980 and December 1994. 8

The economeric resuls of he sudy indicae ha sock reurns in general are negaively correlaed wih boh expeced and unexpeced inflaion and ha common socks provide a poor hedge agains inflaion. As a conclusion, he GFE is rejeced for all counries in his sudy. No only he counry choice bu he mehod of esimaion is also an imporan facor ha affecs empirical resuls. A sudy by Panopoulou (2005) quesions he reason behind he fac ha here is no consensus among economiss abou he rue size of he Fisher effec. This sudy brings a differen perspecive o he lieraure and argues ha he inconsisency of resuls lies on he choice of he esimaion mehod. Panopoulou seeks o find an answer in erms of he bes esimaor choice by including commonly used esimaors such as OLS (ordinary leas square), FMLS (fully modified leas square), JOH (Johansen s Maximum Likelihood), DOLS-ype (dynamic leas square) esimaors and he ADL (auoregressive disribued lag) framework. Oucome of he research saes ha wihin he ADL framework, he Fisher hypohesis is no rejeced. In conras, when DOLS esimaors are used, he rejecion of he hypohesis is observed. Panopoulou concludes ha he choice of he esimaion mehod is a key facor for boh approving and rejecing he Fisher hypohesis. In summary, he evidence abou he Fisher effec is inconclusive since some sudies suppor and ohers oppose he hypohesis. The severiy of inflaion, financial and legal developmen level of he counry, choice of economeric esimaion mehods and ime period analyzed are facors ha seem o affec he resuls obained from various sudies of he Fisher hypohesis. 2.3 The Theory of Purchasing Power Pariy Secion 2.2 analyzed he relaionship beween ineres raes and inflaion expecaions he Fisher Hypohesis. Secion 2.3 presens anoher building block heory of he Inernaional Fisher Effec. The Purchasing Power Pariy (PPP) was 9

firs developed by he Swedish economis Gusav Cassel in 1920s o examine he relaionship beween he exchange raes of differen counries. The PPP holds if and when exchange raes move o offse he inflaion rae differenials beween wo counries. Throughou he lieraure PPP is defined on he basis of he law of one price which assers ha he exchange rae beween wo currencies should be equal o he raio of he price level of idenical goods and services in he wo counries. According o he PPP, increase in he price level of a counry will cause depreciaion of is exchange rae relaive o oher counries, hereby keeping he relaive price of idenical goods he same across counries. Assuming he foreign inflaion rae is relaively smaller han he home counry inflaion rae, he PPP can be represened wih he following equaion: s s +1 s = h, π f, π (3) In Equaion (3), s + 1 and s are he spo exchange raes a ime + 1 and, respecively and π denoes home counry inflaion rae and π is he inflaion h, f, rae of he foreign counry a ime. This equaion saes ha inflaion differenials will be offse by changes in exchange raes. Gaillio s 1970 sudy is one of he earlier sudies and ess wheher price changes can be he primary deerminan of exchange raes. The auhor examines he relaionship beween he relaive degrees of inflaion in US versus some of is indusrialized rading parners and he relaive changes in exchange raes beween hese naions for wo sub periods covering 1900-1904 and 1963-67. Gaillio explains ha boh of hese ime periods are characerized by relaively free movemen of rade and capial and freely converible currencies and, herefore, provide a proper environmen for esing he PPP. The resuls of Gaillio s sudy provide srong supporing evidence for he PPP. 10

In a laer sudy, Webser (1987) analyzes he PPP relaion by using various indusry daa from he 1970s for US and UK. The evidence in his sudy does no suppor he PPP bu indicae a high degree of sensiiviy for he exchange raes in he face of inflaion differenials. Alhough he resuls are no saisically significan, Webser concludes ha he goods ha have significan rading volume beween counries are associaed wih more rapid price adjusmens. For his reason, he auhor argues, he insignifican resuls should no be inerpreed as an argumen agains he PPP. In a more recen sudy, Taylor and Taylor (2004) analyze he PPP debae in a wider perspecive and summarize finding from previous sudies. The PPP predics ha inernaionally raded goods should have he same price anywhere in he world once he price is expressed in a common currency. Auhors menion ha he erm purchasing power pariy was inroduced afer he World War I, during a period of high inflaion raes in indusrialized counries. Many empirical sudies have been conduced o analyze he relaionship beween price levels in differen counries and special indexes were calculaed and published in order o compare he prices of similar/idenical goods in differen counries. One of he mos famous price indexes is he Big Mac index. According o he values of his index, when expressed in common currency prices, an idenical hamburger sells a differen prices in differen counries. The usual explanaion for his observaion is he inclusion of non-radable inpu prices like wages and propery renal coss in hamburger prices in differen counries. Since hese inpus canno be raded inernaionally, heir prices are deermined locally and his may cause deviaion from he law of one price. The sudies ha do no provide supporing evidence for he PPP ypically highligh he imporance of some of he irraional assumpions of he heory, such as zero ransacion coss. In real world, he presence of ransporaion coss, axes, ariffs and non-ariff barriers are likely o cause violaions of he PPP. Besides, Taylor and Taylor poin ou ha daa selecion is very imporan. Since he PPP is based on wha 11

raded goods, i migh be more reasonable o use he producer price index (PPI) raher han he consumer price index (CPI). The PPI ends o conain he prices of relaively more manufacured goods while he CPI migh reflec he prices of relaively more non-radable goods and his may make he PPI a beer measure of price level changes wihin he conex of PPP. Also, empirical evidence obained from Briish and American daa shows ha price levels, expressed in common currency, end o move ogeher in he long run and he correlaion beween wo naional price levels is much greaer wih PPI compared o CPI. Anoher recen sudy abou he PPP is carried ou by Jacobson e al. (2008). This sudy analyzes he period from 1974 o 1999 and he counries UK, Germany, France and Ialy. The resuls indicae ha he heoreical srong PPP relaionship does no hold for all of he analyzed European counries. However, he auhors are able o find evidence of co-inegraion beween nominal exchange raes and prices. Alhough he srong form of he PPP is rejeced, he overall panel esimaed co-inegraed vecor suppors he heory. Auhors conclude ha his resul may be a reasonably accurae approximaion of how nominal exchange raes and price levels evolve over ime. 2.4 The Inernaional Fisher Effec Hypohesis Throughou Secions 2.2 and 2.3, wo key inernaional finance relaionships are analyzed. In his secion, he lieraure abou he Inernaional Fisher Effec and he pariy condiions is reviewed ogeher. The Inernaional Fisher Effec (IFE) is a heory which should be considered as a combinaion of he Purchasing Power Pariy (PPP) and he Fisher Effec (FE). The Fisher heory simply argues ha real ineres raes across counries will be equal due o he possibiliy of arbirage opporuniies beween financial markes which generally occurs in he form of capial flows. Real ineres rae equaliy implies ha he counry wih he higher ineres rae should also have a higher inflaion rae which, in urn, makes he real value of he counry s currency decrease over ime. 12

I is imporan o noe ha wo crucial assumpions are made for he IFE o hold. Firs, invesors view foreign and domesic asses as perfec subsiues, and, herefore, no risk premium is posulaed by invesors. Second, capial markes are perfecly inegraed wih no regulaory and psychological barriers so ha free flow of capial is achieved across counries. PPP %e IFE π π e h e f i i e h e f FE Figure 2.4.1 Figure 2.4.1 summarizes he relaionship beween he hree heories. In he figure, %e denoes he change in spo exchange rae, π π is he difference in e h e f inflaion expecaions beween he home and foreign counry, and i i is he e h e f difference in nominal ineres raes beween he home and foreign counry. Generalized Fisher Effec assers ha nominal ineres rae differences are caused by differences in inflaion expecaions. Besides, if PPP holds, inflaion differenials should be offse by exchange rae changes. In conclusion, he IFE hypohesis saes ha, if real ineres raes are equal across counries, he ineres rae differenial beween wo counries is an unbiased predicor of he fuure changes in spo exchange raes. A his poin, i should be noed ha his does no mean ha he ineres rae differenial is a precise esimaor of exchange raes bu 13

ha he esimaion errors will be cancelled ou over ime. The heories are conneced o each oher such ha, if he home counry inflaion rae is higher han he foreign counry inflaion rae, he home counry nominal ineres rae should be higher han he foreign counry nominal ineres rae. Under he assumpions of (1) wo counry asses being perfec subsiues for each oher, and (2) no barriers o capial marke inegraion, he capial flows o home counry are observed o cover he advanages of higher ineres raes which will resul in a depreciaion of he home currency relaive o he foreign currency. Pariy condiions abou ineres raes are basic definiions which connec exchange raes o ineres raes. The Covered Ineres Pariy posulaes ha he difference in he naional ineres raes and foreign raes for securiies of similar risk and mauriy should be equal o he forward discoun or premium for a currency, bu wih an opposie sign. Insead of he forward rae, if he forecased spo exchange rae is used, hen he Uncovered Ineres Pariy (UIP) condiion is saisfied, which assers ha exchange rae adjusmens will be equal o he ineres rae differenials, bu in he opposie direcion. The UIP condiion is he same as he IFE hypohesis and simply saes ha he expeced uncovered reurns will be equalized in all markes. If he domesic and foreign marke reurns are differen from each oher, hen invesors should be able o earn arbirage reurns. For example, le s suppose ha a ime an invesor decides o inves in he domesic marke: V T, YTL, D) = V (, YTL, D)(1 + i ) (4) ( d In Equaion (4), V is he value of invesmen, YTL denoes he domesic currency, locaion of invesmen is denoed by D for domesic marke and id is he home counry ineres rae beween a ime andt. Therefore, V ( T, YTL; D) value of he invesmen a ime T in he domesic marke. is he fuure 14

If he same invesor decides o inves in he foreign marke, s/he buys foreign currency a he spo exchange rae. Then, he value of he invesmen a ime becomes he following: V (, YTL, D) V (,$, F) = (5) FX (, YTL / $) In Equaion 5, $ denoes he foreign currency, locaion of invesmen is denoed by F for foreign marke, i f is he foreign counry ineres rae beween a ime andt, and FX (, YTL / $) is he spo exchange rae beween home and foreign currency a ime. The invesor s reurn from he foreign marke will be in foreign currency erms and will be equal o he foreign ineres rae a he end of mauriyt : V T,$, F) = V (,$, F)(1 + i ) (6) ( f In Equaion (6), i f is he foreign ineres rae a ime. In order o compare domesic and foreign invesmen reurns, he earnings a he end of he mauriy have o be convered ino he domesic currency by using he spo exchange rae a imet : [ V ( T,$, F) ] [ FX ( T, / $) ] V ( T, YTL, F) = YTL (7) In Equaion (7), FX ( T, YTL / $ ) is he spo exchange rae beween home and foreign currency a ime T. The heory assers ha he Uncovered Ineres Pariy will hold if he reurns from invesing in he domesic marke and he foreign markes are equal o each oher a he end of mauriy: 15

V ( T, YTL, D) = V ( T, YTL, F) (8) The equaliy in Equaion (8) predics ha real reurns across counries will be equalized. Exchange rae movemens will cancel ou he ineres rae differenials. In oher words, he currency of he high ineres rae counry will depreciae hrough ime o equalize he expeced uncovered reurns in all markes. As previously explained, he IFE is a combinaion of he Purchasing Power Pariy and he Fisher Effec. This prediced adjusmen of exchange raes o ineres rae differenials has been quesioned in various empirical sudies from diverse perspecives. In his empirical sudy, Throop (1994) menions he imporance of financial marke inegraion for he IFE hypohesis and analyzes he real ineres rae equaliy across five indusrialized counries during he period of inernaional inegraion of financial markes. The auhor observes ha he inegraion of financial markes has increased dramaically saring from he 1970s afer he collapse of he Breon Woods sysem 1 and governmen imposed barriers o inernaional flow of capial beween indusrialized counries were reduced and mosly eliminaed by 1980s. This inegraion furher caused a decrease in he abiliy of cenral banks o influence heir own naional macroeconomic parameers, such as he nominal ineres raes. Throop ess he relaionship beween he real ineres raes of US, Canada, Germany, UK and Japan during he period beween 1981 and 1994. He explains he well-known Mundell Fleming Model 2 (MFM), which is essenially an exension of he IS-LM model. The MFM assers ha under a flexible exchange rae sysem 1 Breon Woods is an inernaional economic agreemen signed beween 44 naions afer World War II in 1944. Briefly, i was a sysem in which each counry adoped a moneary policy of fixing he exchange rae of is currency in erms of he US dollar and gold. The fixed exchange rae sysem collapsed in early 1970s and a sysem of mosly floaing exchange raes was adoped 2 The Mundell-Fleming Model is also known as he Unhold Triniy, which simply assers ha only wo ou of (1) free capial flow (2) fixed exchange rae (3) independen moneary policy, can be aained a he same ime. I is impossible o have all hree a he same ime. 16

wih saic exchange rae expecaions and perfec capial mobiliy, nominal raes are expeced o be equalized coninuously. Throop indicaes ha afer he 1980s barriers o capial flow were eliminaed for he majoriy of indusrialized counries and in such an environmen only he currency risk was lef for similar invesmens in differen counries. Therefore, according o auhor, he expeced change in he value of he currency is he source of he differences beween he real raes of reurn on similar asses in differen counries. Throop s resuls indicae no causal linkage beween he US and foreign real raes during he period beween 1981 and 1994. This evidence is inerpreed by he auhor o imply ha cenral banks have been able o influence heir domesic ineres raes quie independenly from he influence of ineres raes abroad. In anoher sudy Junilla (2001) exends he radiional Fisher equaion hrough inernaional direcion by inroducing foreign ineres raes and exchange raes ino he sandard Fisher equaion. He firs ess he radiional Fisher hypohesis for Finland and he resuls do no suppor he exisence of a Fisher effec for monhly Finnish daa for he period beween 1987 and 1996. Second, by aking he inernaional dependencies ino accoun, he auhor ess he dependencies beween he Finnish ineres raes and raes from is close rade parners, Germany and US. Resuls of he ess provide supporive evidence for a posiive long run relaionship beween nominal ineres raes and inflaion in Finland, and, moreover, ess of he augmened version of he Fisher equaion indicae ha he Finnish money marke is no independen of he markes of hose counries wih which Finland has a high rading volume. Mishkin (1984) analyzes wheher real raes are equal across counries. Daa from US, Canada, UK, France, Wes Germany, Neherland and Swizerland are used for he period beween 1967 and 1979. Mishkin ess for his equaliy by using he inernaional pariy condiions. UIP and PPP hypoheses are esed independenly and joinly, where he join esing of he pariy condiions means esing for he equaliy of real raes. When individually esed, neiher he PPP nor he UIP are rejeced. However, when hese hypoheses are esed joinly, he null hypoheses wha 17

are rejeced which indicaes ha he join resuls are no supporive of real rae equaliy across counries. Therefore, he basic conclusion of Mishkin is he same as ha of Throop s (1994). The equaliy of real raes is saisically rejeced across counries, which leaves he possibiliy for cenral banks o conrol heir ineres raes independen from oher counries. Mishkin s explanaion for he rejecion of equal real raes is ha he underlying assumpions of he heory may no hold in he real world. For example, he marginal ax raes on ineres paymens migh differ across counries. Also, assuming no ransacion coss is unrealisic. According o Mishkin, real raes can differ across counries because risk premiums asked in he forward exchange marke and securiies denominaed in differen currencies are no perfec subsiues of each oher. The empirical resuls and heir inerpreaion are ofen conradicory when he equaliy of real raes is analyzed across counries. Alhough Mishkin (1984) and Throop (1994) have rejeced real rae equaliy, conradicory resuls are also presen in he lieraure. For insance, Roll (1979) argues ha in efficien capial markes, expeced real ineres raes should be equalized across borders wih he assumpion of perfec inegraion and he sric presence of he PPP. I is imporan o menion ha in his hypohesis, Roll assumes homogeneous goods/asses which are perfec subsiues of each oher and hey are raded wih no coss across counries wih perfec capial mobiliy. In a more recen sudy, Minford and Peel (2007) quesion he findings of Roll (1979). Overall, heir empirical findings are no supporive of Roll s hypohesis of real rae equaliy. According o Minford and Peel, rejecion of equaliy does no imply ha he asse markes are inefficien bu raher ha he heoreical condiions ha have o be me and he underlying assumpions should be evaluaed. Wu (1999) examines he relaionship beween he exchange rae and ineres rae differenials for Japan and Germany agains he US for he period beween 1974 and 1996. In order o es for a long run relaionship, Johansen s co-inegraion es 18

is applied o daa. Resuls are in favor of he exisence of a long run relaionship beween real exchange raes and he expeced real ineres rae differenials. This sudy differs from oher sudies by including cumulaed curren accouns in he regression models. A long run relaionship exiss beween exchange raes and Pineres rae differenials when he cumulaed curren accouns are included in he regressions. The auhor also emphasizes he imporance of he characerisics of he ime period under analysis. According o Wu, conradicory resuls could be found under persisen componen regimes, such as a fixed exchange rae sysem. In a laer sudy, Io and Chinn (2007) examine he relaionship beween depreciaion 3 and ineres rae differenials for 21 developed and 36 emerging marke economies. A se of raher inconclusive resuls are obained from he analysis. The diversiy of resuls is aribued o he differences in he level of financial developmen and he resricions imposed upon capial mobiliy. Resuls are in line wih he previous findings in he lieraure and imply ha higher financial developmen and financial openness end o reduce deviaions from he UIP, while volailiy of inflaion ends o increase he deviaions. Anoher cross counry analysis for he IFE is performed by Shalishali and Ho (2002) for eigh indusrialized counries: Canada, France, Germany, Japan, Neherlands, Sweden, Swizerland and UK Quarerly daa are used covering he period beween 1972 and 1996. According o he auhors, governmens of indusrialized counries are less likely o inervene in he foreign exchange markes and herefore, he resuls for hese counries are expeced o be more saisically significan in favor of he IFE. The OLS regression resuls are in line wih hose of Io s (2007) sudy and show ha while he heory holds for some counries, i does no hold for ohers, bu in mos cases he heory holds excep for a few insances. An ineresing oucome of he sudy is he inconsisency of resuls such ha heory holds when some counries were used as home counry bu rejeced when he same 3 Insead of changes in exchange raes, depreciaion is used by auhor. Depreciaion; is loss of value of counry s currency wih respec o oher currencies, usually in floaing exchange rae sysem. 19

counries are aken as he foreign counry in he IFE equaion. According o auhors, hese resuls sugges ha here are some barriers o foreign rade which may affec exchange rae adjusmens and hese effecs are in addiion o he effecs from ineres and inflaion rae differenials. The period and counries ha are used by Shalishali (2002) are reexamined by Chakrabari (2006) in order o es he relaionship beween real exchange raes and real ineres raes wihin a mulivariae panel co-inegraion framework. The resuls obained from panel ess fail o deec any evidence of co-inegraion beween he wo variables. These resuls indicae ha alhough he same daa are used, differen esimaion echniques may produce differen resuls. A differen perspecive is provided o he lieraure by Jaebeom s 2007 sudy. The auhor examines he relaionship beween real exchange raes and real ineres rae differenials during he 1974-2003 period by using wo kinds of daa, prices of raded goods and non-raded goods, in five indusrialized counries: Canada, Japan, Ialy, UK and US. The Producer Price Index is used o calculae he rae of inflaion and hus he real rae of ineres. The auhor uses he dynamic SUR mehodology for panel daa in order o esimae he link beween real exchange raes and real ineres rae differenials. Empirical resuls suppor he link beween real exchange raes and real ineres rae differenials for raded goods bu no for non raded goods. This finding implies ha raded goods are more plausible indicaors of expeced pariy condiions. The auhor menions ha he link is found for raded goods because he sample counries are close rade parners, and, herefore, hey have relaively sable non-ariff barriers in order o rade wih lower ransacion coss. Conrary o he majoriy of he sudies ha use monhly or quarerly daa, Chaboud and Wrigh (2005) use high frequency daa and analyze he UIP condiion by using daily bilaeral inraday exchange raes beween he Japanese Yen, German Mark, Swiss Franc, Pound Serling and he US Dollar and he corresponding overnigh wha 20

ineres raes. The resuls are supporive of he uncovered ineres pariy wihin his high frequency daa.. Ineresingly, if he daa frequency is exended for even a few hours, i is no longer possible o find evidence of he uncovered ineres rae pariy condiion. Mos of he IFE sudies are conduced on daa from indusrialized counries. I may be plausible o expec ha his relaionship may no hold in emerging counries wih high levels of inflaion. In hese counries, i may ake longer for he ineres raes o adjus o unanicipaed inflaion. As a resul of he uncerainy, high inflaion counries end o inves more in inflaion forecass, and, herefore, may have a greaer incenive o incorporae inflaionary expecaions in required reurns and his migh cause he exchange rae adjusmens o ake longer. In addiion, emerging economies migh be affeced more from developmens in indusrialized counries. Wihin his conex, Özmen and Gökcan (2004) es he validiy of he PPP and he UIP by using Turkish and US daa for he period beween 1986 and 1999. Findings are consisen wih some of he earlier sudies which rejec he pure pariy condiions. The evidence in his sudy suggess ha neiher he PPP nor he UIP can be valid by iself for he Turkish daa. According o he auhors, disequilibrium in inernaional commodiy markes may affec inernaional asse markes. In open economies, policy makers should consider he imporance of he ineracion of PPP and UIP while seing arges for he exchange raes. In anoher sudy which uses he Turkish daa, Saaçioğlu and Korap (2007) invesigae he empirical validiy of he uncovered ineres rae pariy. Economerical resuls obained from he Johansen co-inegraion ess are in favor of he UIP hypohesis in he long run for he Turkish economy. Posiive ineres rae differenials which are in favor of domesic ineres raes cause nearly a one-oone increase in he expeced exchange raes. Jus like Özmen and Gökcan (2004), Saaçioğlu and Korap menion ha he policymakers should consider spo exchange rae movemens while seing arges in open economies. 21

2.5 Conclusion The Inernaional Fisher Effec (IFE) assers ha differences in nominal ineres raes beween wo counries would deermine he movemen of he nominal exchange rae beween heir currencies. As explained in Secions 2.2 and 2.3, he IFE should be considered as a combinaion of he wo well-known inernaional finance heories: he Fisher Hypohesis and he Purchasing Power Pariy. The PPP suggess ha here is a oneo-one relaionship beween he inflaion differenial of wo counries and he percenage change in he spo exchange rae of heir currencies over ime. The IFE suggess ha here is a relaionship beween he ineres rae differenial of wo counries and he percenage change in he spo exchange rae over ime. The IFE is based on nominal ineres rae differenials which are, in reurn, influenced by expeced inflaion. Thus, he IFE is closely relaed o he PPP. Typically, he inflaion expecaion is higher in counries ha have higher ineres raes and his is expeced o cause he depreciaion of such a counry s currency agains he currencies of lower ineres rae counries. Throughou he lieraure, i is generally argued ha evidence ha suppors he exisence of he IFE can be found only if he underlying assumpions are me in he markes. The crucial assumpions of he IFE can be summarized as follows: Perfec mobiliy of capial wihou any regulaion or resricion by governmen insiuions, indicaing ha rade barriers are eliminaed. Invesors are risk neural, herefore, no risk premium is asked by hem. Zero ransacion coss, wih no psychological barriers and ransporaion coss, so ha invesors are indifferen beween counries. 22

Time period under analysis is also imporan because he naure of he exchange rae regimes is crucial for he IFE hypohesis. For example, under a fixed or pegged floa, exchange raes are no allowed o move freely. Raher, hey are eiher se fixed or are allowed o flucuae wihin a pre-announced band. Since exchange raes are no deermined freely in he financial markes, adjusmens necessary for he pariy condiions o hold canno occur. The level of financial developmen in a counry is anoher imporan facor which effecs capial mobiliy. Since insiuional developmen is complee in developed counries, i is less likely for he auhoriies of hese counries o resric mobiliy of capial. The lieraure also presens evidence ha poliical risk and psychological facors play an imporan role in he deerminaion of exchange raes. Moreover, i is widely argued ha emerging markes are affeced more from developmens in indusrialized counries. The empirical evidence abou he relaionship beween ineres rae differenials and exchange raes is inconclusive since here are many sudies ha suppor or oppose he Inernaional Fisher Effec hypohesis. The reasons for hese differen resuls can be summarized as below: 1) The macro-economic characerisics of he period under analysis are imporan. Exchange rae argeing policies enforced by regulaory bodies vary hrough ime. The exernal influences in he marke are examples of violaion of he assumpions menioned above. 2) Financial developmen and capial marke inegraion of counries under analysis are also imporan facors ha affec he resuls of he empirical sudies. Lieraure shows ha close rading parners have more influence on each oher s financial markes. 3) The ype and frequency of daa used and oher variables (such as curren accouns, inflaion differenials ec.) ha are included in regression analyses are also imporan facors. 23

4) The mehodologies used and he pah of he analyses vary among empirical sudies. For example, some sudies do no direcly es he IFE equaion bu use he invered Fisher equaion o es he real ineres rae equaliies across counries. Alhough resuls of he equaions are individually supporive of he hypoheses, when hey are used ogeher, he real rae equaliy asserion is no suppored wih he same daa. As summarized above, when he concern is he inernaional ineracions of markes, resuls obained from empirical sudies are highly diverse. The goal of his sudy is o examine he validiy of he IFE hypohesis across he sample counries, namely he G-5 counries and Turkey. The nex chaper explains he mehodology, he daa and he sample periods used for esing he Inernaional Fisher Effec. 24

CHAPTER 3 DATA AND RESEARCH METHODOLOGY 3.1 Inroducion In his chaper, daa and mehodology are presened. The objecive of he mehodology secion is o explain he economeric mehod used o analyze he effecs of ineres rae changes on exchange raes. Before mehodology, he daa and ime period used in he analysis are described. As explained in deail in Chaper 2, Secion 2.4, he Inernaional Fisher Effec (IFE) is a heory which assers ha changes in spo exchange raes are relaed wih ineres rae differenials across counries. According o he IFE, higher ineres rae counries currencies are expeced o depreciae agains lower ineres rae counries currencies and his equalizes he invesmen reurns across counries. The objecive of his hesis is o es he exisence of his relaionship beween he spo exchange raes and ineres raes in he G-5 counries and Turkey. The sampling period and daa used for analyses are described in Secion 3.2 while Secion 3.3 presens he research mehodology. 25

3.2 Daa 3.2.1 Exchange Rae Daa The heoreical definiion of an exchange rae is he price of one currency agains anoher currency. The exchange rae daa used in his sudy are aken from he daabases of relevan counry cenral banks on he las business day of each monh. Prior o 1999, Deusche Mark and French Franc are used for Germany and France, respecively. Since Germany and France are member saes of he European Union (EU), he official currency of hese wo counries became Euro as of January 1, 1999. For his reason, saring in 1999, Euro is used as he currency for Germany and France. Daa on he hisorical values of he exchange rae beween French Franc and Japanese Yen could no be found; herefore, his exchange rae is excluded from he analysis. 3.2.2 Ineres Rae Daa In he finance lieraure, Treasury bills are acceped as he risk free invesmen ools, and, herefore, i is assumed ha Treasury bills in differen counries are perfec subsiues of each oher. All ineres raes, excep for he Turkish ineres rae, are aken from he Inernaional Finance Saisics (IFS) daabase. For counries oher han Turkey, ineres raes used are he 90-day Treasury bill raes for he period beween January, 1985 and December, 2007. For Turkey, he compound ineres raes of Treasury bills ha are raded on he İsanbul Sock Exchange (ISE) and ha have a remaining mauriy closes o 90 days are used. The Turkish reasury bill daa, covering he period 1995:1 o 1999:12 are obained from he ISE monhly bulleins. For he period 2000:1 o 2007:12, he compound ineres raes are downloaded from he elecronic daabase of he ISE. Since he ineres rae 26

daa for Turkey goes back o only 1995, insead of 1985, in order o avoid wo shor sub periods, Turkey is included in he analyses saring in January, 1999. As explained in Secion 3.2.1, saring in January, 1999, Euro is used as he currency for Germany and France. For his reason, in addiion o he individual ineres raes of Germany and France, he 90-day LIBOR rae for Euro, which is published by he Briish Bankers Associaion 4, is also used for he German and French ineres rae as an alernaive es. 3.2.3 The Sample Period Monhly daa are used for boh exchange raes and ineres raes. The inerval of analysis covers he period from January, 1985 o December, 2007. The analyses are performed over hree sub-periods: (1) January, 1985 o December, 2007 (2) January, 1985 o December, 1998 and (3) January, 1999 and December, 2007. The raionale behind he hree sub-periods is as follows: The firs sub period daa se includes hree counries: USA, UK and Japan. The daa of hese hree counries do no include any srucural breaks, and, herefore, his period allows for esing he hypoheses in he sudy over he longes ime period possible. Afer January, 1999, due o he adapaion of Euro as he official currency by he EU counries, a srucural break exiss in he daa. The firs period is beween January, 1985 and December, 1998 and his period is uses he German Mark and he French Franc. The second period is beween January, 1999 and December, 2007 and his period is analyzed wih Euro. In addiion, he January, 1999 - December, 2007 period is analyzed wih wo differen ineres raes. Firs, 4 For deailed informaion please refer o websie a www.bba.org.uk 27

individual ineres raes of Germany and France are used. As an alernaive es, he 90-day LIBOR for Euro is used insead of he German and French ineres raes. Throughou he hesis, he following abbreviaions are used for counries and heir corresponding currencies: Counry Currency Turkey TR Turkish Lira TL Japan JP Japanese Yen Yen France FR French Franc FF Unied Kingdom UK Serling Serling Germany GER Deusche Mark DM Unied Saes of America USA Unied Saes Dollar USD Figure 3.2.3.1 TR GER FR JP USA UK DM&FF (TL) (DM) (FF) (YEN) (USD) (STERLING) (Euro) TR- (TL) - - - x x x x GER-(DM) - xx xx xx xx - FR-(FF) - NA xx xx - JP-(YEN) - xxx xxx x USA-(USD) - xxx x UK-(STERLING) - x Euro (DM&FF) - Figure 3.2.3.2 Analyzed Couny Pairs Figure 3.2.3.2 summarizes he counry pairs analyzed for exchange rae and ineres rae differenials. NA denoes he unavailabiliy of daa beween Japan and France. Regression equaions are esimaed over he hree sub periods: X: January, 1999 - December, 2007; XX: January, 1985 - December, 1998; XXX: January, 1985 December, 2007. 28

The ineres raes and currencies ha are used over he relevan sub periods are presened in Figure 3.2.3.3 below. Period 1985-2007 1985-1998 1999-2007(A) 1999-2007(B) USA USA USA USA UK UK UK UK Ineres Japan Japan Japan Japan Raes Germany Germany LIBOR (Euro) France France Turkey Turkey USD USD USD USD Serling Serling Serling Serling Currencies Yen Yen Yen Yen Deusche Mark Euro Euro French Franc Turkish Lira Turkish Lira Figure 3.2.3.3 Summary of Ineres Raes and Currencies The following secion presens he research mehodology. 3.3 The Research Mehodology The main quesion asked hroughou his hesis is wheher he ineres rae differenials beween counries are unbiased predicors of fuure changes in exchange raes. The main findings of he lieraure review in Chaper 2 regarding he relaionship beween ineres and exchange raes across counries can be summarized as follows: 1) Resuls from previous sudies are inconclusive due o differences in he selecion of ime frame and ype of daa. For insance, narrow ime frames may cause saisical problems, such as low power of ess and longer periods of daa usually span differen exchange rae regimes, which migh cause biased oucomes. 29

2) Empirical sudies which could no find supporive evidence for he IFE highligh he imporance of assumpions of he heory. Mos of he rejeced resuls are aribued o he unrealisic assumpions of he hypohesis. 3) Purchasing Power Pariy and Generalized Fisher Effec are wo building block heories of he IFE. Therefore, deviaions from hese condiions may cause IFE no o hold. 4) The insiuional and financial developmen level of he counry is crucial such ha emerging economies end o follow he developmens in indusrialized counries. Based on he finding presened and mehodologies used in he previous sudies, he following seps make up he economeric framework for esing he IFE in his hesis: 3.3.1 Uni Roo Tes 3.3.2 Coinegraion Tes and Error Correcion Model 3.3.3 Panel Uni Roo Tes 3.3.4 Panel Coinregraion Tes 3.3.1 Uni Roo Tess Before he ineres and exchange raes can be esed for he exisence of a long-erm relaionship, he ime series properies of hese variables need o be examined. I is necessary o undersand wheher he sochasic process generaing he ime series can be assumed o be consan over ime. The uni roo es is applied o he variables in order o deermine wheher he ime series daa colleced have saionary I(0) or non-saionary I(1) characerisics. Economerically, a saionary process is a random process which has a consan mean, a consan variance and oher saisical properies ha do no vary wih ime. Parallel o his definiion, a process whose saisical properies do change hrough ime is defined as a whaever 30

non-saionary process. If exchange raes ( e ) and ineres rae differenials ( i ) are proven o be non-saionary, i would be difficul o represen he h i f relaionship beween he pas and fuures values of hese variables wihin a simple algebraic model. If wo such random variables are regressed on one anoher, he resuls can be misleading in ha convenional significance ess may end o indicae a relaionship wih a high R 2 and a low Durbin-Wason saisic even hough no rue relaionship exiss beween he variables 5. Such cases creae he socalled spurious regressions in which wo independen and unrelaed ime series are found o be relaed. In his hesis, wo ypes of uni roo ess are applied. The Dickey-Fuller es, developed by D. A. Dickey and W. A. Fuller in he 1970s, is he mos common es used o deermine wheher a uni roo is presen in an auoregressive model. Firs, he Augmened Dickey Fuller (ADF) saisic, which is developed by E. Said and A. Dickey (1984), is used o es he uni roo characerisics of ineres rae differenials and exchange raes. Second, he Kwiaowski, Phillips, Schmid, and, Shin (KPSS) es is performed for he same purpose. 3.3.1.1 Augmened Dickey-Fuller (ADF) Tes Uni Roo es disribuions are affeced by he inclusion of deerminisic erms such as dummy variables, consan erms or ime rends. Therefore, according o he naure of variables ha are being esed, differen es regressions should be used. For non-rending economic and financial series, a regression model wih a consan erm and wihou a rend would be appropriae. In his seing, he ineres rae differenials and exchange raes can be modeled in he following manner in order o es wheher hese wo series have a uni roo, and, hus, are non-saionary: 5 A low value for he Durbin-Wason saisic means ha here is a posiive correlaion beween esed variables. 31

( i i ) = α + δ + u (1) h f 1 ( i h i f ) 1 In Equaion (1), ( i ) is he ineres rae differenial beween home and foreign h i f counry a ime, α is he consan erm, δ 1 is he coefficien ha represens he relaionship beween he curren and one-period lagged values of he ineres rae differenial, and u is he error erm. = + δ 1 e 1 e α + u (2) In Equaion (2), e is he exchange rae beween home and foreign counry a ime,α is he consan erm, δ 1 is he coefficien ha represens he relaionship beween he curren and one-period lagged values of he exchange rae, and u is he error erm. In he following discussions, for noaional parsimony, he ineres rae differenial and he exchange rae variables are boh replaced wih y and he uni roo esing seps are explained using he shorer noaion: = + δ 1 y 1 y α + u (3) In Equaion (3), u is he whie-noise error erm wih a zero mean and a consan 2 variance: WN (0, σ ). In order o es he relaionship beween ime and -1, y 1 is subraced from boh sides of Equaion (3): * y = α + y + u (4) δ 1 1 * In Equaion (4), y = y y 1 andδ 1 =δ1 1. The exisence of a uni roo is esed * wih he following null hypohesis: H : δ 0 0 1 = 32

If he absolue value of he calculaed ADF saisic is smaller han he criical value a he specified significance level, hen he es saisic fails o rejec he null hypohesis. Failing o rejec he null means ha he ime series has he characerisics of a non-saionary series which is inegraed of order 1 [I(1)]. This resul also indicaes ha he ime series esed has a uni roo. The ADF uni roo es is carried ou for ineres rae differenials as modeled in Equaion (1). The log-difference command is used in E-Views for exchange raes o es he presence of uni roo for changes in exchange raes. The mahemaical logic of he log-difference is presened in Equaions (5) and (6). d log( e) log( e ) log( e 1 ) (5) = log( ) log( ) e log ( e e ) 1 e e 1 = (6) e 1 e 1 In Equaion (6), ( e ) e 1 e 1 indicaes he percen changes in spo exchange raes. 3.3.1.2 Kwiaowski Phillips Schmid Shin (KPSS) Tes The KPSS Tes, which is proposed by Kwiakowski e al. (1992), is an alernaive analysis o es he presence of uni roo in ime series. The es differs from oher uni roo ess in a way ha he analyzed series, y, is assumed o be saionary, I(0), under he null hypohesis. H y ~ I(0) o = For his reason, in order o confirm uni roo by he KPSS es, he calculaed saisics should be higher han he criical value. Therefore, conrary o he ADF es, he null hypohesis should be rejeced o conclude for he presence of uni roo in y ~ I(1). 33

The nex secion describes he co-inegraion ess of he variables relaed wih he Inernaional Fisher Relaionship. 3.3.2 Co-inegraion Tess If uni roo es resuls indicae ha he ineres rae differenials and exchange raes are non-saionary, hen boh variables are said o follow random walks. In such a case, regressing one random walk agains anoher may generae spurious resuls. Alernaively, hese variables could be differenced once and he differenced variables can be re-esed for he exisence of a uni roo. Even hough differencing usually solves he problem of non-saionariy, i may cause a loss of informaion since he long-run relaionship hypohesized beween he variables should hold for he level values of he variables. In order o avoid such an informaion loss, one soluion is o creae linear combinaions of he variables under sudy and es o see if hese linear combinaions are saionary. If here exiss a saionary linear combinaion of wo random variables, hen hese variables are co-inegraed. The parameer ha describes he linear relaionship beween he variables is called he co-inegraing parameer and can be esimaed by running an OLS regression of one variable on he oher. The residual of his regression model can furher be used o es wheher he wo variables are indeed co-inegraed. The co-inegraion relaionship in his conex can be described as a model in which a non-saionary dependen variable and a non-saionary independen variable drif ogeher over ime such ha he residuals of he regression equaion are saionary over ime. I is imporan o menion ha he non-parameric coinegraion ess are applied solely o series which are proven o be I(1) in uni roo ess. The Inernaional Fisher Effec can be esed by linking he ineres rae differenial beween wo counries o he change in he exchange raes in he following linear model: 34

e e +1 e = α + i h i β 1 + i f f + ε (7) In Equaion (7), e denoes he exchange rae a ime, i h and i f are he home and foreign counry ineres raes respecively, ε is he error erm and, α is he consan. If β =0 canno be rejeced, hen he change in he exchange rae equals he value of he consan parameerα. In oher words, Equaion (7) can be defined as he basic model o es wheher he ineres rae differenials are unbiased predicors of changes in exchange raes where his predicion is esed by examining he β coefficien. If he foreign counry ineres rae is sufficienly small, Equaion (7) can be rewrien as follows: e +1 ( ih i f ) ε = α + β + (8) In Equaion (8), denoes he change in he spo exchange rae beween ime e + 1 and -1 and he oher variables are defined as before. Equaion (8) is esimaed wihin he Johansen coinegraion framework in order o es for coinegraion beween he exchange raes and ineres rae differenials. Economerically, coinegraion defines he correlaion beween non-saionary variables by esing for he exisence of a uni roo in he residuals εˆ of Equaion (8). In order o es for a uni roo in he residuals, he residuals are modeled similar o Equaion (3). The rejecion of he null hypohesis of a uni roo in he residuals shows ha e + 1 and ( h i f ) i are coinegraed. If he residuals of Equaion (6) are saionary and he ineres and exchange rae differenials are coinegraed, hen he Inernaional Fisher Effec predics ha β in 35

Equaion (8) should be equal o 1. Thus, if he null hypohesis of β =1 canno be rejeced, hen here is evidence in he ime series which suppors he unbiasedness hypohesis of IFE which argues ha ineres rae differenials are unbiased predicors of changes in he fuure exchange raes. Afer esing for coinegraion beween counries on a pair-by-pair basis, he same se of counries are also examined for he exisence of coinegraion on a panel basis. For his purpose, firs, he panel of counry series needs o be esed for he exisence of a uni roo. The following secion explains his mehodology. 3.3.3 Panel Uni Roo Tess In Secions 3.3.1 and 3.3.2, counry pairs are modeled individually and regression equaions are esed separaely for he unbiasedness hypohesis. In his secion, he uni roo hypohesis explained in Secion 3.3.1 is esed by using panel daa. I is widely agreed in he lieraure ha panel-based uni roo ess have higher power han individual uni roo ess. The presence of cross-secions generaes muliple series ou of a single series and he uni roo procedure is applied o panel daa. Panel esimaion brings addiional informaion by evaluaing cross-secional dependencies beween individually consruced regressions. In order o search for a coinegraion relaionship in he enire panel of counries, firs he panel needs o be esed for he exisence of a uni roo. Panel uni roo esing is carried ou by esimaing he following equaion wihin he SUR (Seemingly Unrelaed Regressions) framework: y i i i p i 1 + λit + δ ij yi k ξi (9) k = 1 = γ + α y + 36

In Equaion (9), he p values are deermined from he univariae ADF es resuls for each variable in he equaion. Also, i = 1,2,..., N where N is he number of cross secional equaions and = 1,2,..., T where T is he number of ime series observaions. The null hypohesis for he presence of a panel uni roo is H : α 0. 0 i = If he absolue value of he calculaed ADF saisic is smaller han he criical value a he specified significance level, hen he es saisic fails o rejec he null hypohesis. In addiion o he calculaed es saisics, p-values can also be used o inerpre he resuls of he ess. Failing o rejec he null confirms he presence of a panel uni roo. Once he panel uni roo ess are compleed, if supporive uni roo resuls are found in panel daa, he nex sep is o examine he coinegraion relaionship wihin he panel of counries. Alernaively, if he panel uni roo is no confirmed, furher panel coinegraion esing is no performed. The following secion describes he procedure for esimaing he IFE equaions for differen counries as a sysem in order o es wheher addiional informaion is available across equaions. 3.3.4 The DSUR Esimaion In his secion, individually modeled regressions are esimaed as a sysem wihin he DSUR (Dynamic Seemingly Unrelaed Regression) framework in order o examine he cross secional dependence beween he seleced counries. parameric DSUR esimaor, proposed by Mark e al. (2005), is an economeric mehod o es for mulivariae coinegraion across counries and i ess for longrun cross secional dependence in equilibrium errors. DSUR is applicable for panels where he number of cross secional equaions ( N ) is subsanially smaller han he number of ime series observaions ( T ). The 37

Cross secional panel daa analysis incorporaes addiional informaion ino he esimaions by evaluaing cross secional dependencies beween individually consruced regressions. One requiremen of his analysis is sric exogeneiy which means ha he error erm in each equaion a a given poin in ime mus be uncorrelaed wih he independen variable (he ineres rae differenials) from all equaions in he sysem. This may no be a very realisic assumpion in his sudy since unexpeced macroeconomic shocks in one counry may affec he oher counries considered wihin he sysem and his means ha he forecased error in each of he equaions will be correlaed wih he ineres rae differenials in he oher equaions. The SUR echnique was firs proposed by A. Zellner (1962) as a mehod for analyzing a sysem of equaions simulaneously while allowing he examinaion of error correlaions beween equaions. In oher words, his model is designed o simulaneously es for he correlaion relaionship beween he error erms wihin a sysem of independen equaions. In his hesis, he unbiasedness hypohesis is esed wihin he DSUR framework based on Mark e al. s (2005) mehodology. In he firs sep, he exchange rae change over ime is modeled as a funcion of he ineres rae differenial beween he counry pairs: ( ih i f ) i n e i, + n = i + β i + ε i,, + α (10) In Equaion (10),, is he change in he spo exchange rae for counry pair i e i + n beween ime and +n, ( is he ineres rae differenial for counry pair i i h i f ) i, a ime, and he oher variables are defined as before. For noaional simpliciy, he dependen and independen variables of Equaion (10) are replaced by * x i respecively and each equaion follows: y i and i = 1,..., N has a riangular represenaion as 38

y = x β + u i * i i i (11) x * i = ε i (12) In Equaion (11), y i is he change in he spo exchange rae for counry pair i beween ime and +n and * x i is he ineres rae differenial for counry pair i a ime. Underlined symbols in he equaions sand for vecor represenaions. The DSUR framework assumes ha u i is correlaed wih p and of + ij p ij * x i where + pij denoes he lead and p ij denoes he lag values of * x i. Leads and lags of independen variable are included in he righ-hand side of each equaion in he sysem. Equaion (12) represens he assumpions ha error erms are correlaed. In he nex sep of esimaion, a new cross-secional variable, z, is creaed which is a vecor of all lead and lag values of he variable for each counry pair: * x i * i z * i * * ( x x ) = (13) i, + p,..., i, p In his seing, if here are N cross-secional equaions in he sysem, hen he variable o T: * * z is a vecor of N equaions consruced across ime where goes from 1 * * ( z z ) z = (14) 1,..., N. Since he DSUR sysem ries o deec and ake ino accoun he dependence of he error erm on he ineres rae differenial variable from each of he counry pair equaions, he error erm is projeced on he variable funcion of z * in he following manner: * z and is hus modeled as a 39

ε + * i = φi z ηi (15) Equaion (15) is subsiued ino Equaion (11) as follows: y i = β x + φ z + η i * i i * i (16) In Equaion (16) φi is he vecor of unknown projecion coefficiens and ηi denoes he projecion error, which is orhogonal o all leads and lags of. Furhermore, Equaion (16) can be sacked ogeher in a vecor sysem as follows: * x i Y X = Z * β + η φ (17) Following Mark e al., he moving averages of he error erms are hen incorporaed ino he sysem by creaing he variable w ( η ε,..., ε ), 1 * = as follows: N w ψ ( 11 L) = 0.. 0 0.................. 0 υ.......... ψ NN ( L) υ N (18) In Equaion (18), ψ is he marix polynomial in he lag operaor L, which obeys he funcional limi heorem wih he long run covariance marix Ω wih he following marix represenaion: Ω = Ω ηη 0 Ω 0 εε (19) 40

Finally, he DSUR esimaor wih a known covariance marix formulaed as follows: Ω ηη can be β φ dsur dsur = T = 1 1 X X 1 1 ηη Ω Z [ ] Ω X Z. ηηy Z (20) In Equaion (20), all variables are defined as before. The null hypohesis o es for deecing panel coinegraion requires an equaliy of he β coefficiens across equaions: Ho : β 1 =... = β N In heir sudy, Mark e al. compare he performances of DSUR, SSE, Sysem DOLS and DOLS esimaors in an environmen where he coinegraing vecor exhibis heerogeneiy across equaions. They are able o show ha DSUR exhibis moderae o srong efficiency advanages compared o he oher esimaors. The relaive efficiency of DSUR is proven o increase for larger values of N (number of cross-secional equaions) and T (number of ime periods). The advanage of he DSUR mehodology over DOLS is also menioned in a recen sudy by J. Kim (2007). In his sudy, real exchange raes and real ineres rae differenials are examined wihin he DSUR framework. DSUR provides more precise esimaes compared o DOLS by incorporaing he long run cross secional correlaion in he equilibrium errors. DOLS mehod only includes leads and lags of he firs difference regressors from he own equaion bu no from cross equaions. The DSUR mehod correcs he endogeneiy in equaion i by incorporaing leads and lags of no only he firs difference of he regressors of equaion i bu also regressors of all oher equaions in he sysem. 41

Mark e al. sae ha Equaions (11) and (12) exhibi an endogeneiy problem in he regression esimaes. In order o conrol for he endogeneiy among he variables, Mark e al. sugges ha boh lead and lag values of he independen variable should be included in he regressions. However, here is no sandard mehod for he choice of he number of leads and lags ( p and + ij p ij ). Mark e al. sae ha generally an ad hoc rule is used o deermine he proper p and in empirical sudies. According + ij p ij o his rule, p is se based on he number of ime series observaions such ha p = 1 fort = 50 ; p = 2 fort = 100 ; p = 3 fort = 300. The same rule is adoped in his hesis and hree leads and hree lags are used for he DSUR esimaions. 3.4 Summary The mehodologies described in his chaper all have he purpose of examining he effec of ineres rae differences on he behavior of exchange raes. The sample consiss of six counries: Turkey and he G-5 counries of Unied Saes, Unied Kingdom, Japan, France and Germany. For ineres rae daa, Treasury bill ineres raes are colleced since i is assumed ha Treasury bills are risk free invesmen vehicles and invesors view Treasury bills of differen counries as perfec subsiues of each oher. In his chaper, a four-sep mehodology is consruced o es wheher he ineres rae differenials are unbiased predicors of he fuure changes in exchange raes. These four seps and heir purposes can be summarized as follows: 1) ADF and KPSS uni roo ess are applied o exchange rae and ineres rae differenials o deermine wheher he daa exhibi non-saionariy. 2) Johansen coinegraion es is applied o hose series ha are shown o be non-saionary. Coinegraion ess are performed o es wheher residuals 42

of linearly combined exchange raes and ineres rae differenials are saionary over ime. Saionary residuals are an indicaion of he exisence of a long run relaionship beween exchange and ineres rae differenials. 3) Individually modeled regressions are esed ogeher o analyze crosssecional dependencies. Panel daa for exchange and ineres rae differenials are examined for he exisence of a panel uni roo. If evidence of a panel uni roo is found, hen a panel coinegraion es is performed in order o uilize he addiional informaion ha is assumed o be conained in he panel daa. 4) As a las sep, individually modeled regressions are esimaed as a sysem by applying he Dynamic SUR mehod proposed by Mark e al. (2005). Three leads and hree lags of he independen variable are used in each equaion wihin he sysem., The four-sep procedure described above is applied o monhly ineres and exchange rae value over hree sub periods: (1) January, 1985 o December, 2007 for USA, Japan and UK; (2) January, 1985 December, 1998 for Germany, France, USA, Japan and UK; and, (3) January, 1999 o December, 2007 for Germany, France, USA, Japan, UK and Turkey. The nex chaper presens he resuls of he analysis. 43

CHAPTER 4 RESULTS AND ANALYSIS 4.1 Inroducion In his chaper, oupu obained from E-Views for he differen sages of he analysis is examined and he following subsecions are presened in line wih hese seps: Resuls of uni roo ess for ineres rae differenials and exchange rae changes and he resuls of coinegraion ess are presened in Secions 4.2 and 4.3, respecively. Secion 4.4 presens he resuls obained from panel uni roo ess. Finally, in Secion 4.5, DSUR resuls are presened and analyzed. 4.2 Uni Roo Tes Resuls Uni roo ess resuls are imporan since he presence of a uni roo is necessary in order o coninue wih he coinegraion ess. The following ables presen he resuls of uni roo ess of exchange rae and ineres rae differenials. Tables are organized in accordance wih he sample periods. 44

Table 4.2.1 - Uni Roo Tes Saisics for he 1985-2007 Period ADF Tes (3) Calculaed Tes Saisics Exchange Rae Differenials KPSS Tes (3) Ineres Rae Differenials ADF Tes (3) KPSS Tes (3) Counry Pair: Japan-USA -7.8388 0.3761-1.8866 1.4116 UK-Japan -7.6641 0.2171-2.6441 0.9768 USA-UK -8.2694 0.1360-2.2225 3.0587 Criical Values: 1% -3.9922 0.739-3.9921 0.739 5% -3.4264 0.463-3.4264 0.463 10% -3.1364 0.347-3.1364 0.347 Table 4.2.2- Uni Roo Tes Saisics for he 1985-1998 Period Exchange Rae Differenials ADF Tes (3) Calculaed Tes Saisics KPSS Tes (3) Ineres Rae Differenials ADF Tes (3) KPSS Tes (3) Counry Pair: France-Germany -6.8828 0.4182-3.4574 3.4223 France-USA -6.2940 0.3575-1.3605 1.1784 Germany-USA -6.4851 0.4608-0.8899 0.9922 Japan-Germany -5.4960 0.0448-2.2735 3.2195 UK-France -5.6597 0.1050-1.5514 0.5376 UK-Germany -5.7370 0.1690-0.9748 2.3190 Criical Values: 1% -4.0153 0.739-4.0149 0.739 5% -3.4376 0.463 3.4374 0.463 10% -3.1430 0.347 3.1429 0.347 45

Table 4.2.3(A) - Uni Roo Tes Saisics for he 1999-2007 Period Currency: Calculaed Tes Saisics Exchange Rae Differenials ADF Tes (3) KPSS Tes (3) Euro-Turkey -5.4834 0.5407 Euro-USA -5.7050 0.3969 Euro-UK -6.1231 0.2210 Euro-Japan -5.5369 0.3862 Turkey-Japan -5.8154 0.7939 Turkey-UK -5.1146 0.6825 Turkey-USA -4.9407 0.9071 Criical Values: 1% -4.0495 0.739 5% -3.4540 0.463 10% -3.1526 0.347 Ineres Rae Differenials ADF Tes (3) KPSS Tes (3) Counry pair: Turkey-France -3.1715 1.9146 Turkey-Germany -3.1636 1.9085 USA-France -1.8814 0.5221 USA-Germany -1.5757 0.5159 UK-France -1.8823 0.4966 UK-Germany -2.0746 0.4196 Japan-Germany -1.7856 0.8297 Japan-France NA NA Turkey-Japan -3.1118 1.9201 Turkey-UK -3.1263 1.9096 Turkey-USA -3.1416 1.9038 Criical Values: 1% -4.0486 0.739 5% -3.4536 0.463 10% -3.1524 0.347 46

Table 4.2.3(B) - Uni Roo Tes Saisics for he 1999-2007 Period Exchange Rae Differenials ADF Tes (3) Calculaed Tes Saisics KPSS Tes (3) Ineres Rae Differenials ADF Tes (3) KPSS Tes (3) Counry Pair: Euro (LIBOR)-Turkey -5.4834 0.5408-3.1733 1.9153 Euro (LIBOR)-USA -5.7050 0.3969-1.7909 0.4845 Euro (LIBOR)-UK -6.1231 0.2210-1.7864 0.4179 Euro (LIBOR)-JP -5.5370 0.3863-1.9137 0.7373 Turkey-UK -5.1147 0.6826-3.1264 1.9096 Turkey-USA -4.9408 0.9072-3.1416 1.9038 Turkey-JP -5.8155 0.7940-3.1118 1.9201 Criical Values: 1% -4.0495 0.739-4.0486 0.739 5% -3.4540 0.463-3.4536 0.463 10% -3.1526 0.347-3.1524 0.347 ADF Tes (p) and KPSS Tes (p) denoe he number of lags. The ADF is calculaed wih rend and inercep. The MacKinnon (1996) criical values for ADF and asympoic criical values of KPSS a 10%, 5% and 1% significance levels are provided in he boom hree rows of he ables. NA noes ha he Japan-France exchange rae could no be found Superscrip denoes rejecion of he null hypohesis a all significance levels for he ADF Tes and denoes failure o rejec null hypohesis for he KPSS Tes. Tables 4.2.1, 4.2.2 and 4.2.3 repor he es resuls for he presence of a uni roo for he hree sub periods. For he 1999-2007 period, Table 4.2.3(A) presens he resuls obained wih he German and French ineres raes while Table 4.2.3(B) presens he resuls wih he 3-monh Euro LIBOR. Numbers presened in ables are he calculaed es saisics and criical values are provided a he boom of each able. As explained deail in he mehodology chaper, wo es saisics are presened for each ime series: he ADF saisics which ess he uni roo null and he KPSS saisics which ess he null of rend saionary. As a resul of his difference in he way he null hypoheses are formed in each es, he ADF null hypohesis should be failed o be rejeced and he KPSS null should be rejeced in order o verify he presence of a uni roo in he series. 47

In he ables, he calculaed es saisics for ineres rae differenials are smaller han he criical values for he ADF ess, and, herefore, he resuls verify he uni roo for ineres rae differenials for all counry pairs in all sub-periods. Similarly, he calculaed es saisics are greaer han he criical values for he KPSS ess, and, herefore, hese resuls also confirm he exisence of a uni roo. Uni roo es resuls for exchange rae differenials are more diverse han hose for ineres rae differenials. ADF and KPSS ess resuls are inconsisen wih each oher in ha ADF calculaed es saisics are larger han he criical values for ADF ess. Therefore, uni roo of exchange rae differenials canno be verified wih ADF es in all periods. When he KPSS es resuls are analyzed, i is seen ha calculaed es saisics for exchange raes of Euro-UK during he 1999-2007 period, Japan-Germany, UK- France, UK-Germany exchange raes during he 1985-1998 period, and he UK- Japan and USA-UK exchange raes during he 1985-2007 period are smaller han he criical values. These resuls indicae ha he null hypohesis of saionariy canno be rejeced for hese currencies, which furher implies he rejecion of a uni roo in hese paricular exchange rae series. Since boh he ADF and KPSS ess fail o verify uni roo in he exchange rae differenials for hese currencies hese counry pairs are no esed furher in he coinegraion framework. Figure 4.2.1 presens hose counry pairs ha are esed for coinegraion in each of he sub periods. The nex secion presens he coinegraion resuls. 1985-2007 1985-1998 1999-2007 (A) 1999-2007 (B) USA-Japan France-Germany Turkey-Japan Turkey-Japan Germany-USA Turkey-USA Turkey-USA France-USA Turkey-UK Turkey-UK France-Turkey Germany-Turkey LIBOR-Turkey Germany-Japan LIBOR-Japan France-USA Germany-USA LIBOR-USA Figure 4.2.1 Co-inegraion Counry Pairs 48

4.3 Johansen Co-inegraion Resuls Table 4.3.1- Pairwise Co-inegraion Resuls 1985-2007 Analyzed Pair Number of Coinegraing Vecors Trace Saisic Max- Eigen Saisic Japan-USA None * 59.5785 56.1439 A mos 1 3.4346 3.4346 Table 4.3.2- Pairwise Co-inegraion Resuls 1985-1998 Analyzed Pair Number of Coinegraing Vecors Trace Saisic Max- Eigen Saisic France-Germany None * 39.7843 37.5437 A mos 1 2.2406 2.2406 France-USA None * 26.5337 25.2389 A mos 1 1.2948 1.2948 Germany-USA None * 26.533 25.2389 A mos 1 1.2948 1.2948 Table 4.3.3(A)- Pairwise Co-inegraion Resuls 1999-2007 Analyzed Pair Number of Coinegraing Vecors Trace Saisic Max- Eigen Saisic Turkey-France None * 376.959 318.651 A mos 1** 58.307 58.307 Turkey-Germany None * 376.992 318.836 A mos 1** 58.155 58.155 France-USA None * 391.398 340.325 A mos 1** 51.072 51.072 49

Table 4.3.3(A)- Pairwise Co-inegraion Resuls 1999-2007 (coninued) Analyzed Pair Number of Coinegraing Vecors Trace Saisic Max- Eigen Saisic Germany-USA None * 373.149 339.312 A mos 1 33.837 33.837 Japan-Germany None * 258.249 233.868 A mos 1 24.381 24.381 Turkey-Japan None * 362.994 306.262 A mos 1** 56.731 56.731 Turkey-UK None * 344.407 287.459 A mos 1** 56.947 56.947 Turkey-USA None * 299.335 24.228 A mos 1** 57.055 57.055 Table 4.3.3(B)- Pairwise Co-inegraion Resuls 1999-2007 Analyzed Pair Number of Coinegraing Vecors Trace Saisic Max- Eigen Saisic Euro(LIBOR)-Turkey None * 37.6679 31.8669 A mos 1** 5.8010 5.8010 Euro(LIBOR)-USA None * 37.5547 34.2996 A mos 1 3.2552 3.2552 Euro(LIBOR)-Japan None * 21.2937 18.6229 A mos 1 2.6709 2.6709 Turkey-Japan None * 36.2994 30.6263 A mos 1** 5.6731 5.6731 Turkey-UK None * 34.4407 28.7460 A mos 1** 5.6947 5.6947 Turkey-USA None * 29.9335 24.2280 A mos 1** 5.7055 5.7055 Criical Values None 15.4947 14.2646 5% A mos 1 3.8414 3.8414 Boh Trace and Max-Eigen Saisics are presened o es he null hypoheses of no coinegraing vecors (Ho: r = 0) and a mos one coinegraing vecor (Ho: r =1). Criical values a 5% significance level are provided a he boom of able 4.3.3(B) which are consisenly he same for all periods. * denoes rejecion of he null hypohesis of r =0 a he 0.05 significance level. ** denoes rejecion of r =1 a 0.05 significance level. 50

Tables 4.3.1, 4.3.2, 4.3.3(A) and 4.3.3(B) repor he summary of Johansen coinegraion es resuls. Trace and Max-Eigen saisics for he null hypoheses of no coinegraion (r = 0) are greaer han he criical values for all of he counry pairs in all sub periods. Therefore, he null hypohesis of no coinegraion is srongly rejeced. These resuls confirm he presence of a leas one coinegraing vecor for he analyzed counry pairs. The evidence is summarized in Figure 4.3.1. Period: 1985-2007 Japan-USA Period: 1985-1998 France-Germany France-USA Germany-USA Period (A): 1999-2007 Turkey-France Turkey-Germany France-USA Germany-USA Japan-Germany Turkey-Japan Turkey-UK Turkey-USA Period (B): 1999-2007 EURO-Turkey EURO-USA EURO-Japan Turkey-Japan Turkey-UK Turkey-USA One Coinegraing Vecor X X X X X X X X Two Coinegraing Vecors X X X X X X X X X X Figure 4.3.1- Summary of Co-inegraion Tes Resuls 51

For all of he analyzed counry pairs, a leas one co-inegraing vecor is found. Presence of a leas one co-inegraing vecor indicaes ha he residuals of linearly combined exchange rae and ineres rae differenials are saionary over ime. These resuls suppor he IFE heory which assers ha exchange rae movemens and ineres rae differenials drif ogeher in long run. The following secion presens he panel uni roo es resuls. 4.4 Panel Uni Roo Resuls Table 4.4.1- Panel Uni Roo Resuls 1985-2007 6 Exchange Rae Differenials Ineres Rae Differenials Mehod: Levin, Lin & Chu (LLC) -9.5587 (0.0000) 0.4201 (0.6628)* Breiung -sa -3.3879 (0.0000) -1.6649 (0.0480) Im, Pesaran and Shin (IPS) -12.6329 (0.0000) 0.2040 (0.4192)* ADF - Fisher Chi-square 138.7770 (0.0000) 5.0105 (0.5425)* PP - Fisher Chi-square 401.0370 (0.0000) 6.2579 (0.3949)* Table 4.4.2- Panel Uni Roo Resuls 1985-1998 7 Exchange Rae Differenials Ineres Rae Differenials Mehod: Levin, Lin & Chu (LLC) -10.4372 (0.0000) 0.9660 (0.8330)* Breiung -sa -4.7366 (0.0000) -0.6021 (0.2735)* Im, Pesaran and Shin (IPS) -12.1905 (0.0000) 1.2601 (0.8962)* ADF - Fisher Chi-square 152.449 (0.0000) 8.6282 (0.7343)* PP - Fisher Chi-square 482.761 (0.0000) 9.0989 (0.6945)* 6 Three cross secions are esed wihin he panel framework for boh exchange and ineres rae differenials: Japan-USA, UK-Japan and USA-UK. 7 Six cross secions are esed wihin he panel framework for boh exchange rae and ineres rae differenials: France-Germany, France-USA, Germany-USA, Japan-Germany, UK-France and UK- Germany. 52

Table 4.4.3(A)-Panel Uni Roo Resuls 1999-2007 8 Exchange Rae Differenials Ineres Rae Differenials Mehod: Levin, Lin & Chu (LLC) -13.3976 (0.0000) -1.2095 (0.1132)* Breiung -sa -5.6382 (0.0000) -1.6948 (0.0451) Im, Pesaran and Shin (IPS) -11.2895 (0.0000) -1.3339 (0.0911)* ADF - Fisher Chi-square 136.617 (0.0000) 26.8465 (0.1396)* PP - Fisher Chi-square 336.536 (0.0000) 124.466 (0.0000) Table 4.4.3(B)-Panel Uni Roo Resuls 1999-2007 9 Exchange Rae Differenials Ineres Rae Differenials Mehod: Levin, Lin & Chu (LLC) -13.3976 (0.0000) -0.9845 (0.1624)* Breiung -sa -5.6382 (0.0000) -1.3727 (0.0849)* Im, Pesaran and Shin (IPS) -11.2895 (0.0000) -1.4046 (0.0801)* ADF - Fisher Chi-square 136.617 (0.0000) 20.4789 (0.1158)* PP - Fisher Chi-square 336.536 (0.0000) 97.5005 (0.0000) Saisics are esimaed wih boh inercep and rend. Numbers in parenheses are he calculaed p-values. The null hypohesis for he LLC and Breiung ess is a uni roo wih a common uni roo process. The null hypohesis for he IPS, ADF and PP ess is a uni roo wih individual uni roo process. The specified number of lags is deermined in he same manner as he univariae ADF ess. The probabiliies for he Fisher ess are compued using an asympoic Chi-square disribuion. All oher ess assume asympoic normaliy. * denoes ha he null of panel uni roo is failed o be rejeced a he 5% significance level. 8 For exchange rae differenials, seven cross secions are esed wihin he panel framework: Euro- USD, Yen-Euro; TL-Euro, Serling-Euro, TL-Japan, TL-Serling, TL-USD. For ineres rae differenials, en cross secions are esed wihin he panel framework: France-USA, Germany-USA, Japan-Germany, Turkey-France, Turkey-Germany, UK-France, UK-Germany, Turkey-Japan, Turkey-UK and Turkey-USA. 9 Seven cross secions are esed wihin he panel framework for exchange rae differenials: Euro- USD, Yen-Euro, TL-Euro, Serling-Euro, TL-Yen, TL-Serling, TL-USD. Also, seven cross secions are esed wihin he panel framework for he ineres rae differenials: LIBOR-USA, LIBOR-Japan, LIBOR-Turkey, LIBOR- UK, Turkey-Japan, Turkey-UK and Turkey-USA. 53

Tables 4.4.1, 4.4.2, 4.4.3(A) and 4.4.3(B) repor he esimaion resuls for panel uni roo wih five differen esimaion mehods. According o he calculaed p-values, he null of panel uni roo is rejeced for exchange rae differenials a he 5% significance level. Panel daa do no suppor he exisence of a uni roo in he cross secion of exchange rae differenials. For ineres rae differenials, es resuls wih an aserisk suppor he presence of panel uni roo a he 5% significance level. Calculaed p-values, which are greaer han 0.05, provide evidence ha here is cross-secional independence for ineres rae differenials beween all he counry pairs in he sample. Since he panel uni roo canno be confirmed for exchange rae differenials, i is no possible o coninue he analysis of panel coinegraion. Therefore, he nex sep in he analysis is esimaing he IFE relaionship wihin he DSUR framework. Secion 4.5 presens hese resuls. 4.5 DSUR Resuls In his secion, resuls obained from he sysem esimaion of panel daa are presened. Counry pairs which are presened in Figure 4.5.1 are analyzed wihin he panel framework by using he Dynamic Seemingly Unrelaed Regressions (DSUR) mehod. Table: 4.5.1 4.5.2 4.5.3(A) 4.5.3(B) Period: 1985-2007 1985-1998 1999-2007 1999-2007 Equaions in Panel Sysem JP-USA FR-GER FR-USA EURO-USA UK-JP FR-USA GER-USA EURO-JP USA-UK GER-USA FR-TR EURO-TR JP-GER GER-TR EURO-UK UK-FR JP-GER TR-JP UK-GER GER-UK TR-UK FR-UK TR-USA TR-JP TR-UK TR-USA Figure 4.5.1- Counry Pairs of DSUR Analysis 54

Tables 4.5.1, 4.5.2, 4.5.3(A) and 4.5.3(B) presen he resuls for β coefficien esimaes and he corresponding p-values. As previously explained in he mehodology chaper, hree leads and lags are included in each of he equaions in he sysem for all hree sub periods under analysis. Table - 4.5.1 DSUR Resuls for 1985-2007 β Esimaed Coefficien P- value 1985-2007 β Esimaed Coefficien P- value Coefficien Coefficien Consan** (0.006356) 0.0220 Consan (0.008080) 0.0847 JPUS 0.004978 0.3555 UKJP 0.006282 0.2134 JPUS (1) 0.000796 0.8820 UKJP (1) (0.000110) 0.9825 JPUS(-1) 0.004804 0.3717 UKJP(-1) 0.004198 0.4045 JPUS (2) (0.001330) 0.8019 UKJP (2) (0.001110) 0.8240 JPUS(-2) (0.008127) 0.1275 UKJP(-2) (0.008460) 0.0883 JPUS (3) 0.000600 0.8712 UKJP (3) 0.000943 0.7847 JPUS(-3) (0.000353) 0.9244 UKJP(-3) (0.000360) 0.9174 Consan (0.001410) 0.5898 USUK 0.004737 0.3470 USUK (1) 0.000537 0.9148 USUK(-1) 0.006407 0.2023 USUK (2) (0.002080) 0.6745 USUK(-2)** (0.010080) 0.0427 USUK (3) 0.001376 0.6875 USUK(-3) 0.000387 0.9105 55

Table - 4.5.2 - DSUR Resuls for 1985-1998 β Esimaed Coefficien P- value 1985-1998 Β Esimaed Coefficien P- value Coefficien Coefficien Consan 0.000088 0.9058 Consan (0.003362) 0.1984 FFGE** 0.003365 0.0393 FFUS 0.005845 0.1078 FFGE (1)** (0.003839) 0.0189 FFUS (1) (0.003343) 0.3583 FFGE(-1) (0.000492) 0.7629 FFUS(-1) (0.002514) 0.4871 FFGE (2) 0.000916 0.5707 FFUS (2) 0.000131 0.9708 FFGE(-2) 0.002944 0.0675 FFUS(-2) 0.002746 0.4405 FFGE (3) (0.000479) 0.6452 FFUS (3) (0.000201) 0.9295 FFGE(-3)** (0.002706) 0.0090 FFUS(-3) (0.002725) 0.2302 Consan 0.002396 0.4385 Consan (0.001384) 0.4611 JPGE 0.001482 0.8716 UKFF 0.003168 0.1464 JPGE (1) 0.008096 0.3765 UKFF (1) (0.002055) 0.3467 JPGE(-1) (0.005268) 0.5642 UKFF(-1) 0.000055 0.9796 JPGE (2) 0.009545 0.2971 UKFF (2) (0.001064) 0.6235 JPGE(-2) (0.005222) 0.5691 UKFF(-2) 0.001562 0.4652 JPGE (3) (0.007985) 0.2109 UKFF (3) 0.000690 0.6210 JPGE(-3) 0.000589 0.9262 UKFF(-3) (0.002250) 0.1047 Consan (0.003700) 0.1360 Consan (0.001410) 0.5380 GEUS 0.005396 0.2443 UKGE 0.003390 0.1797 GEUS (1) (0.004060) 0.3801 UKGE (1) (0.002720) 0.2848 GEUS(-1) (0.000970) 0.8350 UKGE(-1) 0.000269 0.9149 GEUS (2) 0.002004 0.6643 UKGE (2) (0.000910) 0.7176 GEUS(-2) 0.001505 0.7430 UKGE(-2) 0.001579 0.5224 GEUS (3) (0.001380) 0.6555 UKGE (3) 0.000640 0.7049 GEUS(-3) (0.002700) 0.3739 UKGE(-3) (0.002350) 0.1525 56

Table - 4.5.3(A) - DSUR Resuls for 1999-2007 1999-2007(A) β Esimaed P- β Esimaed P- Coefficien Coefficien value Coefficien Coefficien value Consan (0.002797) 0.2527 Consan (0.002964) 0.2198 FFUS (0.004487) 0.4800 GEUS (0.007689) 0.1167 FFUS (1) (0.002272) 0.7078 GEUS (1) (0.001712) 0.7278 FFUS(-1) 0.003272 0.6050 GEUS(-1) 0.006666 0.1729 FFUS (2) 0.002889 0.6194 GEUS (2) 0.003213 0.4945 FFUS(-2) (0.001320) 0.8381 GEUS(-2) (0.000021) 0.9965 FFUS (3) (0.000104) 0.9811 GEUS (3) (0.000232) 0.9494 FFUS(-3) 0.002379 0.6205 GEUS(-3) 0.000397 0.9165 Consan 0.003217 0.6160 Consan 0.004564 0.4373 JPGE (0.003075) 0.7509 TRFF** (0.000688) 0.0000 JPGE (1) 0.003767 0.6999 TRFF (1) (0.000018) 0.9088 JPGE(-1) (0.002375) 0.8091 TRFF(-1) 0.000114 0.4875 JPGE (2) 0.012985 0.1732 TRFF (2) 0.000144 0.3678 JPGE(-2) (0.004877) 0.6213 TRFF(-2) 0.000015 0.9226 JPGE (3) (0.008828) 0.2133 TRFF (3) 0.000083 0.5481 JPGE(-3) 0.002659 0.7239 TRFF(-3) 0.000117 0.3997 Consan 0.004582 0.4351 Consan (0.000024) 0.9970 TRGE** (0.000688) 0.0000 TRJP** (0.000764) 0.0000 TRGE (1) (0.000019) 0.9077 TRJP (1) 0.000030 0.8622 TRGE(-1) 0.000115 0.4846 TRJP(-1) 0.000164 0.3450 TRGE (2) 0.000145 0.3656 TRJP (2) 0.000136 0.4204 TRGE(-2) 0.000015 0.9223 TRJP(-2) 0.000145 0.3973 TRGE (3) 0.000083 0.5491 TRJP (3) 0.000104 0.4843 TRGE(-3) 0.000117 0.3987 TRJP(-3) (0.000075) 0.6083 Consan 0.004504 0.4537 Consan 0.000050 0.9929 TRUK** (0.000634) 0.0003 TRUS** (0.000687) 0.0001 TRUK (1) (0.000077) 0.6472 TRUS (1) (0.000014) 0.9297 TRUK(-1) 0.000060 0.7230 TRUS(-1) 0.000106 0.5257 TRUK (2) 0.000154 0.3551 TRUS (2) 0.000115 0.4803 TRUK(-2) 0.000141 0.4031 TRUS(-2) 0.000078 0.6345 TRUK (3) 0.000112 0.4387 TRUS (3) 0.000106 0.4594 TRUK(-3) 0.000013 0.9245 TRUS(-3) 0.000018 0.8945 57

Table- 4.5.3(A) - DSUR Resuls for 1999-2007 (coninued) 1999-2007(A) β Esimaed P- β Esimaed P- Coefficien Coefficien value Coefficien Coefficien value Consan (0.001482) 0.5660 Consan (0.000928) 0.7650 UKFF 0.008175 0.1362 UKGE 0.003324 0.3567 UKFF (1) (0.004027) 0.4701 UKGE (1) (0.000326) 0.9266 UKFF(-1) (0.008637) 0.1041 UKGE(-1) (0.003540) 0.3238 UKFF (2) (0.001314) 0.8031 UKGE (2) 0.000355 0.9174 UKFF(-2) (0.002498) 0.6515 UKGE(-2) (0.002073) 0.5831 UKFF (3) 0.002740 0.4976 UKGE (3) (0.000054) 0.9845 UKFF(-3) 0.006137 0.1478 UKGE(-3) 0.002576 0.3991 Table- 4.5.3(B) - DSUR Resuls for 1999-2007 1999-2007 (B) β Esimaed P- β Esimaed P- Coefficien Coefficien value Coefficien Coefficien value Consan (0.002564) 0.2942 Consan (0.002718) 0.7153 EUUS (0.005054) 0.5326 JPEU 0.012173 0.5708 EUUS(-1) 0.005348 0.5262 JPEU(-1) (0.024561) 0.2486 EUUS (1) (0.005694) 0.4564 JPEU (1) 0.005155 0.8064 EUUS(-2) (0.001109) 0.9018 JPEU(-2) 0.018780 0.3605 EUUS (2) 0.003378 0.6362 JPEU (2) (0.028275) 0.1544 EUUS(-3) 0.000981 0.8809 JPEU(-3) (0.000180) 0.9886 EUUS (3) 0.002478 0.6238 JPEU (3) 0.018608 0.1178 Consan (0.009372) 0.2092 Consan (0.013185) 0.1004 TREU** (0.001372) 0.0000 TRJP** (0.001420) 0.0000 TREU(-1) 0.000057 0.7971 TRJP(-1) 0.000118 0.6035 TREU (1) (0.000122) 0.5843 TRJP (1) (0.000065) 0.7729 TREU(-2) (0.000014) 0.9504 TRJP(-2) 0.000126 0.5719 TREU (2) 0.000180 0.4167 TRJP (2) 0.000186 0.4076 TREU(-3)** 0.000402 0.0436 TRJP(-3) 0.000185 0.3611 TREU (3) 0.000296 0.1459 TRJP (3) 0.000312 0.1324 58

Table - 4.5.3(B) - DSUR Resuls for 1999-2007(coninued) β Coefficien Esimaed Coefficien 1999-2007 (B) P- value β Coefficien Esimaed Coefficien P- value Consan (0.008447) 0.2604 Consan (0.012369) 0.0847 TRUK** (0.001317) 0.0000 TRUS** (0.001329) 0.0000 TRUK(-1) 0.000003 0.9879 TRUS(-1) 0.000043 0.8445 TRUK (1) (0.000163) 0.4787 TRUS (1) (0.000105) 0.6312 TRUK(-2) 0.000118 0.6046 TRUS(-2) 0.000058 0.7904 TRUK (2) 0.000165 0.4698 TRUS (2) 0.000141 0.5170 TRUK(-3) 0.000298 0.1474 TRUS(-3) 0.000301 0.1248 TRUK (3) 0.000337 0.1091 TRUS (3) 0.000308 0.1241 Consan (0.002499) 0.3935 UKEU 0.019169 0.0521 UKEU(-1) (0.013783) 0.1601 UKEU (1) (0.012112) 0.2323 UKEU(-2) (0.003089) 0.7639 UKEU (2) (0.005040) 0.6032 UKEU(-3) 0.007329 0.2850 UKEU (3) 0.008817 0.1828 The negaive numbers in he variable names denoe lags while posiive numbers denoe leads for he ineres rae differenials. Bold resuls wih double aserisks denoe significance a he 5% level. According o he IFE, he ineres rae differenials beween wo counries should be compensaed by changes in he exchange rae beween he currencies of hese counries. Mahemaically, he exchange rae changes should be equal in amoun bu carry he opposie sign as he difference in he ineres raes. When resuls from Tables 4.5.1, 4.5.2, 4.5.3(A) and 4.5.3(B) are analyzed, i is seen ha none of he p-values of he esimaed coefficiens suppor his mahemaical relaionship, excep for he bold resuls wih double aserisks. Resuls for he periods 1985-2007 and 1985-1998 are presened in Tables 4.5.1 and 4.5.2, respecively. Bold esimaes should suppor he presence of an Inernaional wha 59

Fisher Effec. However, for hese wo periods, he significan resuls are sporadic, raher han consisen, and, herefore, canno be inerpreed as supporive evidence of he IFE. For he period 1985-1998, calculaed p-values suppor he exisence of a relaionship beween exchange rae and ineres rae differenials only for he France-Germany pair. The resuls provide evidence of significance in he oneperiod lead and he hree-period lag of he ineres rae differenials. However, when he sign and he magniude of he significan coefficiens are analyzed, i is seen ha he effecs of hese lead/lag values cancel each oher ou almos perfecly. This oucome suppors he previous lieraure which assers ha close rade parners have influence on each oher s financial markes. Also, he resuls indicae ha an over- or under-reacion of he exchange rae change o he ineres rae differenial is correced in he marke in abou four monhs ime. Sill, he exac predicions of he IFE are no observed even in he case of France and Germany. A his poin, i is imporan o remember ha European Union member counries adoped a sysem called he European Exchange Rae Mechanism 10 (ERM) in he early 1980s in order o achieve moneary sabiliy in Europe by reducing exchange rae volailiy. This migh be one of he reasons behind he rejecion of he IFE since he heory is expeced o hold for marke-deermined ineres and exchange raes wih he assumpion of no governmen inervenion. As previously explained in he mehodology chaper, Germany and France adoped Euro as heir common currency in 1999. For his reason, he period 1999-2007 is analyzed wih wo differen ineres raes. Table 4.5.3(A) presens he resuls obained by using he German and French 90-day T-bill ineres raes individually. Ou of he en counry pairs ha are analyzed, significan resuls are only found 10 European Exchange Rae Mechanism was a sysem of pegged exchange raes which allowed individual counry currencies o flucuae in value agains oher currencies in he sysem wihin predeermined bands. Before he inroducion of Euro in 1999, each counry s currency was ied o a baske exchange rae ECU (European Uni of Accoun) which was deermined as a weighed average of paricipaing currencies. 60

wih he Turkish daa. The ess are repeaed by using he Euro LIBOR insead of he individual German and French ineres raes and he resuls, presened in Table 4.5.3(B) are he same. In boh cases, posiive ineres rae differenials in favor of Turkey indicae depreciaion of he Turkish lira agains he corresponding foreign currency. Direcion of he effec suppors he IFE; however, he magniude of he effec is found o be smaller han expeced. For he 1999-2007 period, significan resuls are found only beween he Turkish lira and oher currencies. I is imporan o noe ha while inerpreing he resuls, he macroeconomic characerisics of he period should also be evaluaed. For insance, a he end of 1999, as par of he sand-by agreemen signed wih he IMF, Turkey adoped an exchange rae sabilizaion program 11. Alhough he sysem collapsed in 2001 and exchange raes were allowed o floa free, he moneary auhoriy inervenion while he program was in effec migh have caused he significan resuls obained for he Turkish currency. 11 The sabilizaion program was based on a crawling peg exchange rae regime in which he exchange raes were allowed o flucuae wihin a pre-deermined band. This is a sysem where he cenral bank inervenes in he marke o keep he raes wihin he previously announced band. 61

CHAPTER 5 CONCLUSION The purpose of his sudy is o analyze he relaionship beween ineres raes and exchange raes. This relaionship is raher imporan because here are los of inernaional invesmen opporuniies available in financial markes and he reurn on hese invesmens is he main concern of invesors. The Inernaional Fisher Effec is a heory ha saes nominal ineres rae differenials (hence, he differenial beween he reurns ha can be earned on invesmens of an equal risk) beween counries are relaed o and are unbiased predicors of fuure spo exchange raes. If he heory holds, he advanage ha arises from ineres rae differenials should be cancelled ou by exchange rae adjusmens. Throughou his hesis, he endency of adjusmens of exchange rae movemens o offse he differences in ineres raes across seleced counries is quesioned. The empirical analyses of he sudy consis of four main pars. In he firs par, ime series characerisics of he exchange rae differenials and ineres rae differenials are esed wih radiional uni roo ess. In he second par, variables which are found o be non-saionary as a resul of he uni roo ess are esed for coinegraion wihin he Johansen framework. The empirical resuls of his sudy indicae he presence of a leas one coinegraion vecor for all of he individually modeled equaions in all periods. These resuls imply ha exchange raes and ineres raes drif ogeher in he long run. 12 In he hird par of he sudy, he 12 The presence of one or more coinegraion vecors does no necessarily mean ha ineres rae differenials are precise esimaors of changes in he exchange raes. However, he presence of coinegraion means ha when he wo series are linearly modeled, esimaion errors will cancel ou in ime. 62

variables of ineres are esed again wihin he panel framework for he exisence of a uni roo. Evidence is found for he exisence of a panel uni roo in he ineres rae daa. However, none of he es resuls suppor he exisence of a panel uni roo in exchange raes. Failure o find evidence of panel uni roo in exchange raes prevens furher panel coinegraion analysis. Finally, in par four, he individual counry IFE equaions are esimaed as a sysem wihin he DSUR framework, an economeric mehod recenly proposed by Mark e al. (2005). Resuls obained from he DSUR analysis can be summarized as follows; Supporive resuls are found for he 1999-2007 period for equaions which include Turkey. The calculaed p-values indicae ha, a he 5% significance level, changes in exchange raes can be explained by ineres rae differenials. Direcion of he effec is found as expeced and implies ha posiive ineres rae differenials in favor of Turkey cause depreciaion of he Turkish currency agains he oher currencies in he sample. For he period 1985-1998, supporive resuls are found only beween France and Germany. The resuls provide evidence of significance in he oneperiod lead and he hree-period lag of he ineres rae differenials. However, when he sign and he magniude of he significan coefficiens are analyzed, i is seen ha he effecs of hese lead/lag values cancel each oher ou almos perfecly. This oucome suppors he previous lieraure which assers ha close rade parners have influence on each oher s financial markes. Also, he resuls indicae ha an over- or under-reacion of he exchange rae change o he ineres rae differenial is correced in he marke in abou four monhs ime. The IFE predics a one-o-one relaionship beween exchange rae changes and ineres rae differenials. For he above menioned counry pairs, supporive resuls are found wihin he DSUR framework. However, a crucial poin should be emphasized in ha supporive esimaion resuls could no be found for he magniude of he effec. This means ha he exchange rae movemens are influenced by oher facors in addiion o he nominal ineres rae differenials. 63

Anoher reason for no finding significan resuls can be aribued o money markes which are no fully inernaionalized. The heory assumes perfec capial mobiliy; however, his assumpion is no realisic since here are resricions in world markes ha preven free mobiliy of capial across borders. Invesmen decisions of invesors are effeced by facors such as poliical risk, currency risk, ransacion coss, axes and psychological barriers. Furhermore, moneary auhoriies migh inervene in financial markes by using moneary ools o achieve heir arges. Also, he lengh of he sample sub periods (he longes being 18 years) may no be sufficien o deec a ruly long-erm relaionship beween exchange rae changes and ineres rae differenials. This migh be anoher limiaion of he curren sudy. I is ineresing o noe some implicaions for furher sudy. In his hesis, ineres rae and exchange rae differenials of he G-5 counries and Turkey are analyzed for he period from 1985:1 o 2007:12. In he lieraure survey, i is observed ha when he daa se is changed, differen resuls are possible o be obained. Therefore, furher analyses can be performed wih alernaive counry pairs. Addiionally, he ime period under analysis can be expanded. The longer he ime period, he more informaion is likely o be included in he analysis, and, herefore, new resuls can be expeced. While deermining he sample period, aenion should be paid o changing exchange rae regimes. Floaing or fixed exchange rae regimes which are adoped by moneary auhoriies would affec he oucome of he empirical ess. Also, new analyses can be performed by changing he ype and frequency of he daa. In his hesis, monhly daa are used for exchange raes as recorded by cenral banks and he 90-day T-bill raes are used for ineres raes for he G-5 counries and for Turkey, compound ineres raes of T-bills raded in he secondary marke are used. Alernaively, deposi raes or LIBOR can be used insead of he T-bill raes. 64

As explained in deail in Chaper 2, he IFE hypohesis is closely relaed wih he heories of Fisher Effec and he Purchasing Power Pariy. The building block heories should also be considered and he failure of IFE across he G-5 counries can furher be evaluaed wihin his conex. In his hesis, he effec of ineres rae differenials on changes in exchange raes is analyzed. However, addiional facors, such as accumulaed curren accouns or log of consumer price indexes of seleced counries could be included in he analysis. No only ineres rae differenials bu also hese oher facors may affec he movemen of exchange raes. These facors can be evaluaed wih modified equaions in fuure research. 65

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