Essays on Exchange Rates Behaviour

This thesis aims to investigate the exchange rate behaviour and its abnormal movements. By doing so, I introduce a novel instrument which contributes to analyse the exchange rate behaviour. I then apply the new instrument, called wavelet analysis, to investigate the relation of exchange rate to price ratio (PPP proposition) and the relation of exchange rate and interest rates (UIRP proposition). Finally, I concentrate on the specific movements in exchange rate that leads to currency crises. The second chapter introduces wavelet analysis which has been extensively applied to many situations with favourable results. Many researchers are expanding wavelet application in a variety of fields such as signal processing, physics and astronomy. It has remarkable potential properties that can be applied in the disciplines of economics and financial. The first attempt of this chapter is to introduce wavelet analysis in an intuitive manner. The next step involves reviewing the potential and possible contributions of wavelet analysis in empirical economic and finance literature. I also examine the validity of short-run and long-run purchasing power parity (PPP) hypothesis applying wavelet analysis. The results indicate that the impact of price ratio on exchange rates are positive and close to unity. The findings confirm that the PPP holds for long-run horizon. The third chapter deals with examining the relationship between spot exchange rates and the interest rate differentials (UIRP) for ten bilateral currencies against the Pound Sterling in short and long time horizons, simultaneously. The distinguishing feature of this study is to apply wavelet transform to decompose the time series into short-run and long-run time horizons. I find out both negative and positive relationships between exchange rates and interest rate differentials. The former is supported by the fixed-price model in short-run and the latter is supported by flexible-price model in long-run. In the forth chapter, I evaluate the potential leading indicators of a currency crash by applying a quarterly panel of 26 developing and developed countries. I split the definition of currency crashes according to different generations of the currency crises in the literature. Based on two different definitions, I use two binomial logit models, which provide estimations of the probability of a currency crash occurring. The empirical results reveal that domestic credit growth rate, ratio of reserves to GDP, current account, output growth rate, and ratio of national debt to GDP are consistently associated with the early warning theory. According to definitions provided by this chapter, the findings show that current account and GDP growth rate in the developing countries and current account and national debt in the developed countries are significantly related to the crash incident. This chapter also criticizes the previous papers for their construction of exchange rate overvaluation indicator and proposes a recursive Kalman filter to express overvaluation. The findings confirm that overvaluation of exchange rate is not an appropriate predictor of currency crashes unlike previous studies.