The Relative Term Structure and the AustralianUS Exchange Rate - Literature review Example

ARTICLE REVIEW Student’s Name Tutor’s Name Course Date Part A: Article Summary In their article “The relative term structure and the Australian‐US exchange rate,” Bui and Fisher (2014) predict the AUD/USD exchange rate by modeling yield curves of both the Australia and the United States (US) using Nelson-Siegel factors. The authors use the three Nelson-Siegel factors; level, slope and curvature to provide reflection on movements of microeconomics variables and to account for variations experienced in the domestic yields. The authors use Chen and Tsang approach in predicting the relative movements of economics variables from one country to another. They use the approach to model the AUD/USD exchange rate using samples ending February 2014 and the pre-crisis ending July 2007. The authors have further broken their discussions in sections for clarity. They first discussed the assets approach in modeling the exchange rates. The asset approach applies the discounted present value to predict future values of fundamentals. They used equation one and two in modeling this approach (Bui and Fisher, 2014). The variables in the equation are associated with Taylor rule in the two countries. The authors argue that some of the variables in the equation to cover for the assumed uncovered interest rate. According to the authors, this asset approached had limited success because of the assumptions constrain the specification, and it is devoid of information on investors future expectations. They further claim the Chen and Tsang approach deviates from the asset one because their approach uses yield curves of the two countries (2013 cited by Bui and Fisher, 2014). The information from the yield curve captures expected future value of the fundamental variables. The authors concur that Chen and Tsang are success over their sample because first, there are plenty of literature supporting the same and secondly, the yield curves reflects the investors’ expectations (Bui and Fisher, 2014). The authors further take readers through Chen and Tsang modeling using Nelson-Siegel framework in developing yield curves. The approach identifies the yield curves in terms of level, slope and curvature, which account for all the variations in yields (as cited in Bui and Fisher, 2014). Level factor in the model affects the interest rate and as it increases, so do the higher medium and long-term inflation. The shape of the yield curve is very indicative of the economic performance. According to Bui and Fisher, an increase in slope factor, a flatter yield curve, captures the expectations of the activity in the business cycles. In addition, they claim extensive literature supports the findings. On yield curve, curvature factor provides the position of monetary policy. According to the authors, at low policy rate, investors would predict future higher inflation and economic growth for medium term and increase in the policy rate. In the model, shape parameter (0.0609) is constant and used in equation four (Bui and Fisher, 2014) to obtain time series for the three factors. The authors provide regression results for Australia in table one. Panel A indicates that the larger the level factor, the higher the expected inflation over the medium term in Australia. Additionally, Chen and Tsang provided report for U.S. that indicates increase in level factor increases the expected inflation from three months to one year away and increase in slope factor results to lower expected output nine months to one year away (2013 cited by Bui and Fisher, 2014). Furthermore, the yield curve factors for both Australia and the U.S provide information used in determining their bilateral exchange. Under relative yield curve and the AUD/USD exchange rate, the authors evaluate exchange rate using relative yield curve factors. The graph of the AUD/USD rate shows a huge depreciation of the Australian dollar between June 2008 and January 2009. According to the authors, investors sought refuge in USD. As the Australian dollar appreciated, the slope and the curvature factor varied considerably compared to the level factor. In addition, they show a positive correlation between the relative slope and the curvature factors, which are more volatile. According to them, the US Federal Reserve made the situation easy by repurchasing medium and long-term bonds and resulted into the upward shift in the relative curvature factor around 2008. The authors further provide interpretation for the relative factors by using different scenarios. At one percent incremental of the level factor, yields also increases across all maturities by one percent higher in Australia relative to the U.S. in turn; inflation is expected to be higher in Australia than in U.S.. Again, in anticipation, when they increase the relative slope factor by one percent, the Australian yield factor flattens relatively to that of the U.S. In their sub-sample July 1992-July 2007 results, the authors address biased due to the overlapping between observations and the usu al the standard error by using Newey-West corrected standard error to report t-statistics. In addition, they show that the relative curvature factor is used in predicting changes in the AUD/USD exchange rate from one month to twelve months. The results also show that inclusion of a dummy variable is important and only significant in regressions with non-overlapping data. In their conclusion, the authors acknowledge that yield curve patterns provide the most reliable means to understanding the views of investors concerning future path of the economy. Part B: Article Appraisal First, I must admit Bui and Fisher have done a recommendable job in this article. From the onset of their article, they are clear on their intentions on what they want readers to have. They want readers understand their discussion by providing insights of what is expected early on in the article. In their introduction section, the authors provide conclusively if not comprehensively overview of what the paper is all about. They outline what they plan to do in their article. For instance, they stressed on the use of the information from the yield curves for both countries in predicting the AUD/USD exchange rate. They further give previous instances where the approach has been used in determining the exchange rate of other currencies. This allows readers to acclimatize themselves with the areas of discussion they expect to encounter in the main sections of the paper. Still in the introduction, the authors further go beyond their own work and represent the other individual approaches that have worked in the same scenario. By adapting Chen and Tsang approach, they provide confidence to the reader on the validity of the eventual results in the main sections. Under the introduction, they have provided an adequate overview of the whole article and all parts on a major analysis was captured. At the end of the introduction section, the readers have a clear view on what the paper involves including various sections of the paper. Therefore, the introduction prepares the reader for the rest of the sections in the article. Bui and Fisher have organized their article into various sections to separate different areas of discussion. This separation into different sections allows readers to have clear understanding of each part while distinguishing main subjects of discussions in each section. Most significantly, the authors provide conclusions on their results allowing readers to have a sound judgment on the results based on their knowledge on thea topic discussed. In every section of the paper, I think the authors provide adequate information on their discussions. They define all parameters and explain their roles in a function. Every time they introduce function that defines a model, the parameters are defined. For instance, the authors consistently define symbols that denote yield curve factors including level factor, curvature factor and slope factor. They further provide explanation on the limits of the dummy variable, which can only be used in regressions of non-overlapping data. This provides readers with clear presentation of models and the results obtained In their analysis in every section, Bui and Fisher provide adequate insights into their analysis by deploying the use of more than one approach or model to evaluate the exchange rate. Firstly, they used assets approach providing possible outcome of the analysis before concluding that it has limited success due constrains. They use the assets approach yet they know they would not use it for their final analysis. They approached the analysis from this perspective to enable readers understand why they opted for the Nelson-Siegel as the model of choice for the analysis. Analysis using more than one approach is also to eliminate any thoughts people might have concerning the results when another method is used. Remember initially they stated in the introduction section that they would be using yield curves for each country, which is only available in the Nelson-Siegel model. In their second, the authors settle on the Chen and Tsang approach based on Nelson-Siegel model to have a conclusive analysis. Further, in their analysis, the authors provide most possible outcomes of the model for the Chen and Tsang approach by interpreting various yield curve factors through supposed values. Using such values would provide possible scenarios from the model and authenticates arguments the authors might bring forward after obtaining results of the analysis. It also shows the behavior of the yield curve thus help in predicting the economic activities. The authors provide sufficient information from the analysis. Throughout the article, the authors used both the tables and figures in representing their findings. In providing their results, they have used statistical methods and formulas such as t-statistics and R-squared statistics to get their answers. Despite all the efforts in the analysis, the authors seem to deviate from their analysis and sometimes look like reporting a previous work by Chen and Tsang rather than the current analysis. Therefore, I think they ought to have used the Nelson-Siegel to model the yield curve the same way Chen and Tsang did and not describing as if Chen and Tsang is performing another analysis for them. Their conclusion is quite impressive in terms of their stance on their analysis. However, it is of my opinion that should have mentioned in their conclusions where and under what conditions assets approach would be appropriate. At least it will not leave readers pondering where it can be used with its limitations. Bibliography Bui, A.T & Fisher, L.A., 2014. The relative term structure and the Australian‐US exchange rate. Macquarie University. Read More