Nonlinear Dynamics of Spot and Forward Exchange Rates: An Application of a Seminonparametric Estimation Procedure

Abstract: This paper applies the seminonparametric nonlinear impulse response analysis proposed by Gallant, Rossi and Tauchen to weekly spot and forward Swiss franc/US dollar exchange rate. Five empirical regularities are found: (i) symmetric mean and volatility reaction pattern of the spot rate to pure spot shocks; (ii) symmetric mean, but asymmetric volatility responses of the forward rate to pure forward premium shocks; (iii) weak feedback from the forward to the spot rates; (iv) a forward premium shock triggers off a four-week cyclical impulse response, which is transmitted to a similar response cycle of the spot rate; (v) the volatility responses are neither monotone nor highly persistent as reported by numerous applications of ARCH models. Our finding offers a strong empirical support to the exchange rate model suggested recently by McCallum in which the monetary policy authorities systematically manage interest rate differentials so as to resist changes in exchange rates but also to smooth interest-rate movements.;