Model-free evaluation of directional predictability in foreign exchange markets, страница 2

Second, from an economic point of view, the directional predictability of foreign exchange returns is more relevant to many financial applications than forecasting the conditional mean dynamics. For example, Leitch and Tanner (1991, 1995) showed that the direction-of-change criterion may be better able to capture a utility-based measure of forecasting performance such as economic profits (see Granger and Pesaran, 2000; Pesaran and Skouras, 2001; for further discussion). Market timing, one form of active asset allocation management, is essentially the prediction of turning points in financial markets. There have been a number of tests for market timing ability in the literature (e.g., Henriksson and Merton, 1981; Cumby and Modest, 1987; Pesaran and Timmermann, 1992), although they are intended to evaluate the directional predictability of models or forecasters.

Third, the direction of changes is an important maneuver in foreign exchange rate markets. For instance, the technical trading rules widely used by foreign exchange dealers (Taylor and Allen, 1992) are heavily based on forecasts of direction of changes (e.g., Pring, 1991). Also, central banks under pegged exchange rate systems often use the direction of exchange rate changes as a key instrument to maintain monetary stability. They will intervene in the foreign exchange market when the domestic currency is expected either to appreciate or depreciate beyond a certain, often politically determined threshold. Hence the study on the direction of changes will provide important insights to market practitioners and policy makers.

Finally, the direction of changes can be an alternative instrument for the link between foreign exchange rates and interest rates. Most early studies on this subject have focused on the relationship between the level of (expected) exchange rate changes and interest rate differentials, formally known as ‘uncovered interest rate parity (UIP)’. Unfortunately, while the theoretical implication of the UIP–interest rate differentials serve as a useful predictor of the future spot foreign exchange rates is important, its validity has been questioned on various grounds in the literature. This motivates us to look for an alternative relationship, that is, whether interest rate differentials are useful to predict the direction of future foreign exchange rates. This still links foreign exchange rates with interest rates, but relaxes a rather restrictive condition imposed by UIP, under which the expected changes in a foreign exchange rate should exactly counterbalance the difference between domestic and foreign interest rates.

One interesting issue in the foreign exchange markets is currency crisis. There have been a variety of theoretical and empirical studies on currency crisis (see Kaminsky et al., 1998, for an excellent survey). Due to quantifying difficulties, a currency crisis is typically represented by an indicator (binary) function, which is equal to unity if there is a sudden fall of foreign exchange rate beyond a certain threshold, namely, a large negative change. Several recent studies further suggest that some models for binary dependent variables (i.e., the currency crisis indicator) may have descriptive or predictive ability for future currency crises (e.g., Frankel and Rose, 1996a; Berg and Pattillo, 1999; Kumar et al., 2003). Perhaps even more interesting is when a currency crisis spreads from one market to another (or they occur simultaneously), which is commonly referred to as ‘market contagion’. This growing and pervasive phenomenon suggests that during a crisis period a large adverse price change in one market will be closely followed by a large adverse price change in another market, regardless of market fundamentals (King and Wadhwani, 1990), implying a quite strong positive directional dependence between two markets during the turmoil period.^[1] In pursuit of better understanding of directional movement, it is useful to examine the directions of large changes and large joint changes.