A COUNTRY-SPECIFIC MODEL TO SHED LIGHT ON

THE EXCHANGE RATE PUZZLE:

COMMODITY PRICES AND EXCHANGE RATES

M. Banovic, U. Fretzen and B. Noyan1

With special thanks to Hoyong Choi

Abstract

Exchange rates dictate the global economic arena and are responsible for a great share
of the uncertainty that international businesses find themselves exposed to. While the
Uncovered Interest Parity theoretically explains exchange rate changes, empirical
research has increasingly criticized the applicability of this framework. Considering
the apparent inability to explain exchange rate fluctuations, we set out to establish a
more comprehensive framework that can shed light on the exchange rate puzzle. In line
with previous research we find that UIP does not hold and that interest rate differentials
can at best explain exchange rate changes partially. We prove that other economic
parameters, namely GDP growth, current account growth, and inflation cannot predict
exchange rate movements. The main additional value of this paper lies in the
proposition of a country-specific approach. Every country is subject to a distinct
interplay of commodity prices which influence the exchange rates of countries that are
particularly active in international trade of commodities.

Keywords: UIP, exchange rates, interest rates, inflation rates, GDP growth rates, current account
growth rates, commodities

1
Erasmus University Rotterdam, Rotterdam School of Management Bachelor Thesis, Burgemeester Oudlaan
50, Bayle Building, 3062 PA Rotterdam.
 Introduction
The world economy is rapidly changing. In the advent of globalization and increasing
international trade, exchange rates have become key pillars of our financial system. In this
context, the global economy, as characterized by predominantly flexible exchange rate
systems, has increased in complexity and volatility. As a result, exchange rates have on the one
hand become a major driver of competitive advantages. On the other hand, they add substantial
risk to any internationally operating company as well as global investors. Therefore, there is a
multitude of situations in which managers are required to make decisions subject to exchange
rate risk. On a broad level, this risk can impose volatility on businesses through two channels,
as each company is affected by different degrees of transaction and economic exposure.

Transaction exposure is the risk that an exchange rate might change unfavourably after two
companies have established financial obligations. Some enterprises import goods from other
countries and thereby incur payables denominated in foreign currencies. Should the foreign
currency appreciate before the company has made its payments, the business might incur
significant additional costs. Such unfavourable exchange rate fluctuations do not only concern
importers but also affect global exporters, who book receivables in foreign currencies. Hence,
transaction exposure is a serious concern for any business involved in international
transactions. In other cases, globally operating organizations might expect a stream of foreign
currency denominated royalties from a franchise operating in a different country. The home
currency value of each royalty payment is dependent on the conversion ratio implied by the
exchange rate. An example of such problem is the case of the Walt Disney Company, which
has franchised its theme park concept to the Oriental Land Company to open Tokyo
Disneyland. In reverse, Walt Disney Company was entitled Japanese Yen royalty payments. In
this situation, Disney feared transaction risk as the JPY (Japanese Yen) could depreciate against
the USD (US Dollar), which would erode Disneys USD cash receipts.

Another form of international risk results from economic exposure, which can affect businesses
through two channels. On the one hand, the exchange rate exposure of assets represents a
substantial source of risk for businesses that possess assets in a foreign country, as the value of
the asset denominated in a companys home currency fluctuates alongside the respective
exchange rate. On the other hand, economic exposure can result from operating exposure,
which is the effect that random changes in the exchange rate can have on a firms competitive

2
position (NASDAQ.com, 2017). More simply, it can be defined as the extent to which the
firms operating cash flows are affected by exchange rate fluctuations. This risk affects all
companies who face competition from other countries. For instance, an exporter benefits from
a sudden depreciation of his currency, which could enable him to take over significant shares
in the international market.

Considering the multitude of associated risk factors, operational as well as financial hedging
represent suitable strategies to reduce the exposure to exchange rate volatility. Examples of
operational hedging strategies are the alignment of foreign denominated costs to revenues or
the selection of low-risk production sites. Financial hedging involves derivative securities such
as futures, forwards, options, or swaps. The suitable strategy for a specific firm primarily
depends on the size and type of expected currency exposure. To reduce risk exposure as well
as to decide for the most efficient hedging strategy that decreases risks while increasing return,
managers are required to proactively anticipate changes in the foreign exchange market (FX
Market). In light of this complex problem, our paper seeks to identify factors that allow
managers to predict exchange rate changes by examining specific economic parameters.
Therefore, the research question reads as follows:

How much do various economic parameters influence exchange rate changes between
currencies?

In order to find a compelling answer to our research question, we analyse the perspectives of
three interdependent hypotheses2. The first one focuses on the effects of interest rate
differentials (Hypothesis 1), the second one elaborates on the impact of differentials of general
economic factors (Hypothesis 2), and the third one examines the effects of commodity prices
(Hypothesis 3) on exchange rate changes.

Hypothesis 1
One of the predominant theories in academic research is the estimation of future exchange rates
using interest rates. The predominant theory is the Covered Interest Parity (CIP), which directly
links exchange rates to interest rates, whereby the difference in interest rates of two countries

2
A hypothesis is a tentative proposition about the causes or outcome of an event or, more generally, about
how variables are related (Passer, 2014). More simply, a hypothesis is an educated guess regarding the
outcome of the research question.
3
determines the differential between the forward and the spot exchange rate. While this
phenomenon has empirically been widely substantiated at least for developed countries
(Ferreira & Len-Ledesma, 2003), it is not applicable in predicting future spot exchange rates.
Nevertheless, it represents the origin of the Uncovered Interest Parity (UIP), a parity
condition in which the difference in interest rates between two countries equals the expected
change in the respective exchange rate. More specifically, UIP implies that high interest rate
currencies depreciate. In this respect, UIP, if validated, would represent a valuable framework
for the financial management of internationally operating firms. As interest rates are publicly
available, managers could use changes in interest rates to predict exchange rates and thereupon
take the necessary measures to hedge their cash flows. Therefore, this paper will first test the
UIP along the following hypothesis:

Hypothesis 1: High interest rate currencies tend to depreciate.

Hypothesis 2
Considering the complexity of international economies, we assume that there are further factors
besides interest rates that contribute to exchange rate fluctuations. Specifically, we test for the
impact of three key macroeconomic factors. Firstly, we expect inflation rate differentials
between two countries to have an impact on exchange rate changes, as the relative purchasing
power between two countries should remain constant. According to the purchasing power
parity theory, a country that experiences comparably high inflation will see a drop in its
currency value (Bansal & Dahlquist, 1998). Secondly, the current account, representing the
balance of trade between a country and its trading partners, is expected to have a considerable
impact on exchange rate fluctuations. As an indicator of the future demand and supply for a
certain currency, the differential between the current account growth of two countries
potentially impacts the value of a countrys currency (Dornbusch & Fischer, 1980). Thirdly,
the gross domestic product growth (GDP growth) differential represents an indicator of
economic prosperity. A healthy economy is expected to attract foreign direct investment, which
increases the demand for a currency and ultimately drives up its value compared to other
currencies (Ito & Krueger, 1999). If a relationship between these economic parameters and
exchange rates can be identified, our model could aid managers in hedging their investments,
as data for these factors is publicly available through sources such as the OECD or databases

4
such as Bloomberg and Datastream. The following hypothesis summarizes the previous
reasoning:

Hypothesis 2: Inflation rate differential, current account change differential, and GDP
growth differential have a significant correlation with exchange rates between two countries
currencies.

Hypothesis 3
Hypothesis 1 and 2 seek to explain the exchange rate puzzle through general economic
parameters. However, finding a universal model to predict exchange rate changes by the means
of key macroeconomic factors may not be possible. Therefore, we formulated a third
hypothesis that considers countries individually when determining factors that drive
fluctuations in their exchange rate. Each country trades a different set of commodities, and its
economic health is thus influenced by changes in those commodity prices. By arguing that
economic health mediates a countrys attractiveness for foreign investments we assume that
changes in commodity prices lead to the volatility in returns of the domestic currency. Based
on the previous reasoning, we hypothesize a relation between certain commodity prices and
specific currencies. If this relationship can be found it will help managers hedge against their
currency risk, as commodity price data is readily available.

Hypothesis 3: For countries that are large exporters or importers of certain commodities,
there is a significant correlation between price changes of these commodities and exchange
rate changes.

Structure of this paper

In the following section, we introduce the theoretical framework that surrounds each of the
three hypotheses. The order in which we discuss the three hypotheses will remain the same
throughout the entire paper to provide the reader a clear structure. After introducing the theory,
we present a critical evaluation of eleven studies that analysed similar concepts as we do. In
the remainder of the first part of this paper, a critical synthesis will summarize the implications
of these papers with the goal to outline the results of previous research in this field. This is not
only important for a comparison of our own results, but also provides a first indication about
the predictive power of each variable that is analysed in this paper. The second part of the paper

5
presents our research project. We introduce an outline of our dataset as well as the methodology
used in conducting the empirical analysis. Afterwards, we will present the results for each of
the three hypotheses and interpret these regarding their managerial relevance. Ultimately, we
will conclude by summarizing the overall findings for managers, elaborate on the limitations
of our study and suggest relevant topics for further research.

Theory
In the following, we will introduce the theoretical framework that underlies the three
hypotheses tested in this paper. This paper evaluates the impact of various economic
parameters (including commodity prices) on the value of currencies. In this respect, currency
is the unit of interest and represents the focal unit in this paper. The theoretical domain is all
currencies in the world, at all times. Although the study is broad in nature and seeks to
determine implications for any currency, we must confine the limits of our study. The
availability of data constraints the feasibility of conducting research on the theoretical domain,
limiting our population to currencies traded on the NYSE3 only.

All three hypotheses seek to derive claims about the value of currencies. However, as the value
of currencies can only be established in comparison to other currencies, its measurement is
conducted through exchange rates. Consequently, spot exchange rates represent the dependent
concept in each of the three hypotheses. Spot exchange rates can be defined as the ratio at
which the principal unit of two currencies may be traded (Merriam-Webster, 2017). Exchange
rates are quoted as the price of one unit of foreign currency denominated in the domestic
currency. The independent concepts vary throughout the three hypotheses. Their effect on
exchange rate changes is measured as the unstandardized regression coefficient, beta. This
impact cannot be assumed to be causal. While associations can be established, we can neither
exclude the impact of other factors that potentially mediate the relationship between the
variables nor a reverse relationship. This limitation cannot be circumvented, as we cannot
conduct an experiment because macroeconomic factors cannot be controlled or simulated.

3
The New York Stock Exchange (NYSE) is the worlds largest stock exchange, based in New York (Wee, 2017)
6
Hypothesis 1:
The first hypothesis tests the UIP theorem, a parity condition that predicts an expected
exchange rate to be equal to the difference in interest rates between two countries. UIP is
derived from the CIP in the following way (Chinn and Meredith, 2004). CIP is expressed as:
","$% 1 + ",%
=
" 1 + ",%
where " represents the value of a foreign currency unit in terms of domestic currency at point
t, ","$% is the market price of a forward contract on S that expires k periods from t, ",% is the
k-period domestic interest rate, and ",% is the equivalent interest rate of the foreign instrument.
Taking the logarithm of both sides leaves us with the following equation, where the logarithm
is indicated by lowercase letters:
","$% " = (",% ",% )
This equation supposes a risk-free arbitrage condition that is valid independently from investor
preferences. However, the forward rate can vary from the expected future spot rate due to risk
aversion tendencies of investors. The resulting premium can be considered a compensation for
the perceived riskiness of keeping foreign instead of domestic assets. The risk
premium, ","$% , is defined accordingly:
","$% = 5 ","$% ","$%
where 5 ","$% represents the expected exchange rate at t for point t+k. Substituting this
expression into the CIP formula gives us the expected change, , in the exchange rate between
the periods t and t + k. The expected change is a function of the interest differential minus the
risk premium:
5 ","$% = ",% ",% ","$%
In line with the assumption of risk-neutral investors, ","$% becomes a constant term zero.
After adjustment for noise and assuming unbiasedness, the following UIP equation results:
5 ","$% = ",% ",%
As the theory suggests, we seek to validate UIP by examining the effect of interest rate
differentials on exchange rate changes. Thus, the interest rate represents the independent
concept of hypothesis 1. Specifically, we test the proposition that an increase in the interest
rate differential leads to a proportionate decrease in the exchange rate. The interest rate
differential is described as the domestic interest rate minus the foreign interest rate.

7
Hypothesis: High interest rate currencies tend to depreciate.

Focal unit: Currency

Domain: All currencies in the world, at all times

Independent concept: Interest rate

Dependent concept: Exchange rate

Relation: Probably causal, probabilistic, positive

Conceptual model:

Figure 1: Parameters of hypothesis 1

Hypothesis 2:
As we do not expect that interest rates can explain all exchange rate changes, our second
hypothesis aims to uncover other macroeconomic factors that potentially influence the return
of currencies (Bansahl & Dahlquist, 1998; Dornbusch & Fischer, 1980; Ito & Krueger, 1999).
We suggest a measurable influence of three additional macroeconomic factors on exchange
rates, namely (1) the inflation rate differential, (2) the current account growth differential, and
(3) the GDP growth differential.
(1) The literature suggests that a country with a comparably high inflation rate experiences
a decrease in its currency value. This assumption is based on two lines of reasoning
(Bansahl & Dahlquist, 1998). Firstly, an increase in the price level of goods in a country
makes the export of its products and services less competitive compared to countries
with a lower price level of goods. Subsequently, international demand for goods and
services decreases alongside a decrease in demand and value of the respective currency.
Secondly, the increasing price level of goods increases the attractiveness of cheaper
products from foreign countries. To buy foreign products, importers must convert the
domestic currency into foreign currency. This increase/decrease in foreign/domestic
currency demand leads to a depreciation of the home currency.
(2) A current account deficit implies that a country is importing more than it is exporting,
or more precisely, that it spends more on foreign trade than it is earning through foreign
trade. To make up for this deficit countries are required to borrow capital from foreign
sources, resulting in a higher demand for foreign currencies than it receives through

8
 exports as well as a higher supply of domestic currency than the trade market demands
for its products. Consequently, the domestic currency depreciates until domestic goods
are attractive for the export market and foreign goods are too expensive for the import
market (Dornbusch & Fischer, 1980).
(3) GDP represents an indicator of economic health. Its growth signals future prosperity of
an economy and thereby represents a valuable indicator for foreign investors. In this
respect, a comparatively high GDP growth is expected to attract comparatively more
foreign investment than a low GDP growth. As a result, the demand for the domestic
currency increases compared to foreign currencies of countries with lower GDP growth
(Ito & Krueger, 1999).

Based on the previous reasoning, the three variables represent the independent concepts of
hypothesis 2. The differentials of each of the three additional economic factors are defined as
domestic rates minus foreign rates. The hypothesis entails the following three propositions:
1. A comparatively higher inflation rate in the domestic country leads to an increase in
the exchange rate
2. A comparatively higher current account balance growth in the domestic country leads
to a decrease in the exchange rate
3. A comparatively higher GDP growth in the domestic country leads to a decrease in the
exchange rate
Hypothesis: Inflation rate differential, current account change differential,
and GDP growth differential can predict changes in exchange
rates between two countries currencies.
Focal unit: Currency
Domain: All currencies in the world, at all times
Independent concepts: Inflation rate, Current account growth, GDP growth
Dependent concept: Exchange rate
Relation: Probabilistic
Conceptual model:

Figure 2: Parameters of hypothesis 2

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Hypothesis 3:
The independent concepts of the first two hypotheses comprise key macroeconomic factors
that potentially impact the currency value of any country. Besides these generic influencers,
we expect the exchange rates of countries that are particularly involved in international trade
to be dependent on the price fluctuations of exported and imported goods. As there is no direct
measurement of the export and import of readily finished goods, we use commodity prices as
measurement parameter to analyse country specific dependencies between trade levels and
exchange rate changes.

Bailey and Chan (1993) analyse risk premia of commodity futures in the largest exporting
countries of commodities and provide findings of a positive association of commodity futures
to a countrys systematic risk (specifically to stock and bond market risk). In addition, Baum
and Barkoulas (1996) research the connection between exchange rate changes and time varying
risk premia, stating that currency futures vary positively with the riskiness in a countrys
overall economy. Therefore, one could assume that certain commodities play an important role
in explaining the risk premia of countries that largely depend on the export and import of these
commodities. Based on this commodity-risk relation, there are two eminent theories that
underline the importance of a commodity-to-currency relationship for commodity-exporting
countries. The sticky price model states that increasing commodity prices have an upside
pressure on the countrys real wages and non-traded goods (Chari et. al, 2000). Consequently,
the relative price between traded and nontraded goods is expected to be restored by an
appreciating domestic currency. The portfolio balance model implies that a countrys currency
is highly correlated with foreign asset supply and demand (Lewis, 1988). An increase in
commodity prices ultimately leads to a surplus in an exporting countrys balance of payments
as well as increasing foreign investments in the domestic currency due to attractive growth
opportunities. The resulting additional demand in the domestic currency increases its value
compared to other currencies.

Based on the previous reasoning, we hypothesize a relation between commodity price changes
and exchange rate changes. In this respect, commodity prices represent the independent
concept of our third hypothesis.

10
Hypothesis: For countries that are large exporters or importers of certain
commodities, there is a significant correlation between price
changes of these commodities and exchange rate changes.
Focal unit: Currency
Domain: All currencies in the world, at all times
Independent concepts: Commodity price
Dependent concept: Exchange rate
Relation: Probabilistic
Conceptual model:

Figure 3: Parameters of hypothesis 3

Critical Evaluation of existing literature

In the following two sections, we first evaluate eleven research papers regarding their fit for
our research, before critically synthesizing their results. The aim of such evaluation is to assess
the quality of each paper regarding various key aspects, such as measurement, research
strategy, or population. The studies found to be of high quality during the evaluation are then
synthesized. Their results are integrated to gain a comprehensive overview of the current state
of research regarding the exchange rate puzzle. This enables us to focus our paper on areas
where little research has been conducted, potentially leading to new insights with high utility
for managers. The evaluation and synthesis entails three sets of literatures, each discussing the
theoretical background of one of our three hypotheses. In total, we analyse eleven papers, of
which seven deal with our hypothesis 1, while two articles cover each of the other two
hypotheses. Since the sets of literature concern different hypotheses, a comparison of all papers
across the three topics is not reasonable. Nevertheless, to qualify as relevant literature for our
research question certain aspects are consistent across all eleven articles. These are the unit of
analysis, the dependent variable, the population and sampling method, and with one exception
also the research strategy.

11
Unit of Analysis
The unit of analysis in each paper matches the focal unit of our hypotheses, namely currencies.
This was the main criterion in searching for papers, and thus other studies with different units
of analysis were not considered.

Dependent Variable
Each of the papers analyses effects on expected exchange rates, matching the dependent
concept we defined in our study. This implies that each of the eleven selected papers evaluates
a hypothesis that is related to our research question.

Independent Variable
The independent concept of each of our articles matches one of the independent variables of
our hypotheses. For hypothesis 1, all seven papers use the same independent variable as we do,
interest rate differentials. Regarding hypothesis 2, we selected two additional articles that
discuss the effects of economic growth and current account growth on exchange rate
fluctuations. For the effect of inflation rate differentials, we draw insights from two previously
discussed papers. Each of the four papers uses at least one independent concept that we include
in hypothesis 2. Both commodity-related articles use constructed country specific commodity
indices as independent variables. As we do not use indices but individual commodities, a direct
comparison between the respective results with our findings has to be conducted with caution.

Measurement
The measurement in each article is conducted through the effect sizes of OLS-regressions. The
effect size in each article for hypothesis 1 and hypothesis 3 is described as the slope-coefficient
beta (). This effect size can be described as non-standardized, as the changes in independent
and dependent variables are not standardized by means of the respective standard deviations.
Consequently, one cannot compare the portrayed effect sizes to other effects beyond the
hypothesis. The precision of each effect size is determined by calculation of the confidence
interval (CI), where SE denotes the Newey-West standard error of the point estimates. On the
contrary, the article from Dornbusch and Fischer (1980) evaluates the relationship between
general economic factors and expected exchange rates qualitatively only. Therefore, this paper
has no quantitative effect sizes that could be compared. The article from Ito and Krueger (1999)
applies a OLS-regression without providing standard errors. Although this characteristic
12
renders the articles incomparable to other evidence, they add essential reasoning that underlines
the potential impact of the macroeconomic factors in our model.

Research Strategy
Regarding the research strategies used in the papers, all articles that refer to hypotheses 1 and
3 use the same strategy, a time-series study. These can be classified as panel studies, which
examine changes in a certain number of cases over time and whose hypotheses each suggest a
link between interest rate differentials or commodity price changes and exchange rate changes.
Such research strategy cannot exclude the influence of external variables. By using panel
studies one can merely find proof of associations between the variables, while causality can
only be established through experimental research strategies. Experiments are not feasible on
a macroeconomic scope as manipulation of independent variables is impossible. Regarding the
papers relevant for hypothesis 2, Ito and Krueger (1999) conduct a time-series study, while
Dornbusch and Fischer (1980) deviate from this model by solely reasoning theoretically
without substantiating the line of argumentation with data. While this research strategy is not
preferable as it is not underlined by empirical results, this paper presents a theoretical
foundation for our own research regarding hypothesis 2.

Population
None of the studies explicitly mentions the population from which the samples are drawn.
Nevertheless, we assume that they all try to find broad, universally valid outcomes that are
meant to apply to all currencies in the world, at all times. However, since valid research can
only be conducted for currencies that are publicly traded, we conclude that only these constitute
the population. The only cases that lie within the domain but outside of the population are non-
traded currencies, such as the North Korean Won. Based on the previous assumptions, none of
the studies makes claims beyond its population. Both the domain and the population are highly
heterogeneous, meaning that the instances of the focal unit, currencies, highly differ from each
other. Therefore, it is difficult to find claims that are valid for the whole population based only
on a sample of the overall population.

Sampling
Up to 23 different exchange rates are examined per study. These are selected based on
purposive sampling. While this form of sampling does not permit generalization, it represents
13
an appropriate strategy as complete data is not available for all variables, countries, or every
time horizon. Through this forced choice, the authors inadvertently influence the set of
instances for which they can reasonably make claims, e.g. if mostly developed countries are
chosen it is not possible to make valid claims for emerging countries. This limitation is
highlighted by the authors, who acknowledge this issue by analysing only the effects in the
sample. The resulting implications are only applied to cases that closely resemble those in the
sample. Thus, the sampling techniques and the theoretical deductions in the papers can be
considered legit.

Data
With regards to the data, the measurement of interest rates and exchange rates is regulated by
the markets. For most studies, data is downloaded through databases such as Reuters
Datastream or Bloomberg. Due to the objective nature of the data and the acceptance of
Bloomberg and Reuters in the international science community, the data can be considered
valid, reliable, and trustworthy. The same applies to the data that has been used in the research
papers regarding the macroeconomic factors and the commodities. Only one UIP study
(Lothian & Wu, 2011) does not use downloaded data but constructs its data from various
alternative sources, as the study goes back 200 years and the respective data is not available in
common databases. Therefore, this study resorts to issues of the Federal Reserve Bulletin, two
articles by Michael D. Bordo (The Bretton Woods International Monetary System: A
Historical Overview, 1993 & The Long-Run Behaviour of the Velocity of Circulation, 1987),
one by Milton Friedman (Monetary Trends in the United States and the United Kingdom,
1982) as well as Sydney Homers book A History of Interest Rates (1977) and the IMF.
Nonetheless, incomplete datasets have been remarked as limitations in 4 papers. Therefore,
their findings are evaluated with particular caution as blank spots in a dataset potentially
decreases the validity of outcomes. However, the incompleteness in these datasets is described
as marginal, which is why we do not exclude any paper for this reason.

Conclusion
Overall, most of the literature reviewed is fit for its purpose. Most UIP studies test the
framework exactly along the lines of the parameters specified in the theory of our hypothesis
1. However, the papers concerning hypothesis 2 and 3 differ from our framework. Dornbusch
and Fischer (1980) do not conduct empirical research on the impact of the current account

14
differential but argue qualitatively only. In addition, both papers on commodity currencies
research the effect of country specific commodity indices on exchange rates only, instead of
focusing on individual commodities. However, as the studies are simply intended to provide a
theoretical background for our own research, such differences in methodology are not
considered a reason for exclusion.

Apart from the previous concerns, there are two papers that require additional examination of
data sets. Lothian & Wu (2011) do not use downloaded data but obtain their data from books
instead. As these sources have been found credible and reliable, this study will be accepted.
Flood & Rose (2001) state that one should not take their beta coefficients at face value due to
non-normalities associated with jumps at currency crises. This lowers the value of this paper
for result comparisons regarding hypothesis 1. Nevertheless, we do not completely disregard
the paper, as it contains important macroeconomic findings for our hypothesis 2. Thus, we
choose not to include it as input for hypothesis 1, but only use it as an indicator for the potential
impact of inflation rate differentials on exchange rates.

Critical Synthesis of Reviewed Literature

In the pursuit to find predictors of exchange rate movements, researchers have examined
multiple influences. Especially the highly-criticized interest rate puzzle has been of central
interest. While other economic factors have still received moderate attention, only few
academic articles evaluate more exotic relations, such as the relationship between changes in
commodity prices and exchange rate changes. In this section, we present the findings of the
previously evaluated academic research articles for each of the three hypotheses. We start by
discussing the results from articles regarding UIP, before focusing on the general economic
factors as well as commodity studies.

Articles Related to Uncovered Interest Rate Parity

Due to the popularity of studying the relationship between interest rates and exchange rates, it
is impossible to include all the relevant literature. Since the overall conclusions across studies
are similar, a careful selection of the most pertinent seven papers suffices to give an insightful
overview of findings regarding the UIP theorem. We chose a wide variety of papers, covering
developing and emerging countries as well as various time horizons from 200 years to intra-

15
daily. Table 1, Appendix A outlines effect sizes (slope-coefficients) as well as CIs of each of
the seven papers. In the following, we will discuss each paper individually starting with the
longest horizon (200 years) and ending with an intra-daily study.

The regression for UIP on ultra-long time horizons of almost 200 years as performed by
Lothian and Wu (2011) yields positive beta coefficients for the FRF (French Franc) and USD
(US Dollar) against the GBP (British Pound Sterling). The largest value of beta is unusually
high with 10.05 (SE: 3.63) for the evaluation of FRF/GBP between 1914 and 1949, raising
questions about the validity of the measure. When looking at shorter time frames, the authors
propose to reject the UIP hypothesis in multiple instances across different currency pairs. Thus,
the authors make the case for examining UIP over longer time frames, but are themselves still
not able to prove UIP even for such long-time periods.

Bansal and Dahlquist (1998) do not find any consistent support for UIP in their study of
developed and emerging economies over a timeframe of more than 20 years. The regression
yielded predominantly negative values, with the lowest one being -8.400 (SE: 3.11) for the
AUD (Australian Dollar) and the highest one being 1.350 (SE: 0.63) for the CZK (Czech
Koruna). Due to this high dispersion and inconsistency of results, the implications of this study
are unclear.

Mehl and Cappiello (2007) test UIP for 7 developed and 3 emerging country currencies against
the USD at 10 and 5 year horizons. For the longer time frame, the authors find more support in
favour of UIP for major floating currencies than for emerging market currencies. The lowest
value of is -0.29 (SE: 0.36) for the SEK (Swedish Krona), while the highest value is 0.860
(SE: 0.09) for the DEM (German Mark). On the contrary, the results of the 5-year time frame
yield only marginal support due to higher standard errors for both developed as well as
emerging market currencies. The beta coefficients from the 5-year regression yield the highest
value of =1.57 (SE: 0.33) for the INR (Indian Rupee), while the lowest value found is =-
2.01 (SE: 0.48) for the SGD (Singapore Dollar).

In the paper by Chinn and Meredith (2004), the authors test UIP for the G7 countries on time
horizons of 3, 6, and 12 months as well as 17 years. For each of the three short term regressions
they find negative beta coefficients in 5 out of 6 cases. Below, Table A reports the lowest and
highest values for each of the timeframes. On the long horizon, all coefficients are positive
16
and 4 out of 6 are closer to unity than to zero, providing more support for UIP than the shorter
timeframes. The lowest beta found is 0.197 (SE: 0.151) for the ITL (Italian Lira), while the
highest value is 1.120 (SE: 0.335) for the CAD (Canadian Dollar). The authors explain that
over longer horizons, the temporary effects of exchange market shocks fade and the model
results are dominated by more fundamental dynamics that are consistent with the UIP
hypothesis.

Extreme results from Chinn and Meredith (2004)

Currency 3 months 6 months 12 months

Italian Lira 0.518 (SE: 0.606) 0.635 (SE: 0.670) 0.681 (SE: 0.684)

Japanese Yen -2.887 (SE: 0.997) -2.926 (SE: 0.800) -2.627 (SE:0.700)

Table A: reports the highest as well as lowest regression coefficients for each of the time horizons used by Chinn and Meredith (2004).

Chaboud and Wright (2005) test four developed countries with high frequency intraday data
from 16:30 to 21:00 (morning trading in Tokyo) New York Time and find that the slope
coefficients in the UIP regression are close to unity and precisely estimated. At this 4.5-hour
horizon, the values span between 0.79 (SE: 0.69) for the CHF (Swiss Franc) and 1.44 (SE:
0.72) for the GBP (British Pound Sterling). The positive results diminish if the time horizon is
extended by just a few hours. On a multi-day horizon (28.50 hours) the coefficients change
significantly and range from =1.26 (SE: 1.51) for the JPY (Japanese Yen) to =2.70 (SE:
1.40) for the GBP. Overall, the study indicates that UIP potentially holds over very short
periods of time. Considering the high standard errors and the marginal time frame, the utility
and relevance of the findings appear rather limited.

In conclusion, the results of studies regarding UIP are contradictory. UIP seems to hold over
very short overnight horizons as shown by Chaboud and Wright (2005). Only adding a few
hours to this timeframe diminishes this outcome, and most effect sizes deviate significantly
from unity. While Chinn and Meredith (2004) find that UIP does not hold for time frames of 3
months, 6 months, and 1 year, Bansal & Dahlquist (1998) find support for UIP in emerging
markets in the short term. Consequently, we can conclude that there is no consensus for UIP
for short term horizons of up to one year, indicating that UIP does not hold as a universal
theory. A similar case can be made for timeframes of 5 to 200 years, where the discussed
studies reveal contradicting and opposing results. While Chinn and Meredith (2004) find more
17
support in the long-term of 17 years than in the short-term, Bansal and Dahlquist (1998) do not
find any significant predictive power of UIP in a time frame of 20 years. Mehl and Cappiello
(2007) further underline this discrepancy, as they find support for UIP only for exchange rates
of developed countries, but not for emerging countries. Regarding an even longer time span,
Lothian and Wu (2011) share the scepticism regarding UIP, as they do not find any substantial
support in the ultra-long term of 200 years.

Besides the diverging effect sizes, large standard errors across all studies lower the precision
of the point estimate and further decrease predictive power. Overall, most studies suggest a
statistically significant influence of interest rate differentials on exchange rate movements,
which is generally not close to unity. This discrepancy in effect sizes suggests that UIP does
not hold and one cannot expect the exchange rate changes to equal the interest rate differential.
The divergence from UIP suggests that there are other factors besides interest rates that drive
exchange rates. In line with this conclusion, Bansal & Dahlquist (1998) propose that
differences across economies are systematically related to per capita GDP, inflation, and
inflation volatility. Instead of forecasting exchange rate changes only through UIP, they
suggest considering other economic parameters.

Articles Related to General Economic Factors

Inflation rate differential
One factor that potentially mitigates the exchange rate change is the differential of inflation
rates between two countries. Generally, the currency of a country with low inflation is expected
to appreciate as the purchasing power increases compared to other countries with higher
inflation rates. As part of their studies on UIP, Flood & Rose (2004), Bansal & Dahlquist (1998)
and Lothian & Wu (2011) test the impact of inflation rate differentials on expected exchange
rate changes. Flood & Rose (2004) find an effect size of =0.31, which is comparable to the
positive effect sizes of =0.36 and =1.03 that Bansal & Dahlquist (1998) find in their two
samples. The corresponding standard errors of 0.4, 0.27, and 0.29, respectively, substantiate
the homogeneous findings of a somewhat positive impact of inflation rate differentials on
exchange rate changes. The 95% confidence intervals run from -0.47 to 1.09, -0.17 to 0.89, and
0.46 to 1.60, respectively. Thereby, they depict a comparatively wide spread, which diminishes
the reliability of the point estimates. In contrast to these two studies, Lothian & Wu (2011) also
find a negative correlation between inflation differentials and expected exchange rate changes.

18
While their findings depict a positive relation of =3.82 for the FRF/GBP (French Franc and
British Pound Sterling), the USD/GBP (US Dollar and British Pound Sterling) depicts a
negative effect size of =-1.53. Although the authors do not provide a standard error the
negative effect size can be seen as considerable, as it lies outside the confidence interval of the
other two papers. Although not consistent in their findings, the sheer observation of sizeable
effects in all three studies implies a potential impact of inflation rate differentials on exchange
rates. These effect sizes can be found in Table B.

Effect sizes and confidence intervals for macroeconomic factors

Effect Size Lower Confidence level Upper Confidence Level

Flood and Rose 0.31 -0.47 1.09

Bansal & Dahlquist 0.36 -0.17 0.89

1.03 0.46 1.6

Lothian & Wu 3.82 - -

-1.53 - -

Table B: outlines the effect sizes of the three respective papers that analysed the relationship between inflation rate differential and expected
exchange rate changes.

Current account growth differential

Dornbusch and Fischer (1980) state that the current account growth influences the exchange
rate change. Specifically, they point out that a higher current account growth yields a higher
domestic currency demand over a certain timeframe. This increased asset accumulation can be
considered as a predictor of exchange rates. However, the findings are derived theoretically
and are not substantiated by empirical statistics. This poses a clear limitation regarding
comparability. Other studies about the impact of the current account on the exchange rate
differential could not be found. Nevertheless, as Dornbusch and Fischer (1980) reason logically
towards a sizeable impact of current account changes on exchange rates, this factor will be
considered in our hypothesis 2.

Economic growth differential

In analysing the Balassa-Samuelson effect, Ito and Krueger (1999) discuss economic growth
as a potential determinant of the nominal change in exchange rates. According to their

19
reasoning, economic growth leads to higher investment and thereby to a growth in export,
which results in a current account surplus. In line with Dornbusch and Fischer (1980), the
surplus leads to the appreciation of the domestic currency. As part of their research on UIP and
the forward premium puzzle, Lothian and Wu (2011) and Bansal and Dahlquist (1998) have
quantified the influence of economic growth on the exchange rate change through GDP growth
differentials. Lothian and Wu (2011) study only developed countries, whereas Bansal and
Dahlquist (1998) incorporate emerging countries. Neither of the two studies incorporates
comparisons to other papers regarding the influence of GDP on exchange rate changes.

Lothian and Wu (2011) find an effect size of =1.13 for the GDP growth differential between
the USA and Great Britain. Although they do not report any standard error for the beta
coefficient, the materiality of this value points towards a significant impact of the economic
growth. Bansal and Dahlquist (1998) depict strongly negative effect sizes of =-3.78 and =-
1.42, with considerable standard errors of SE=1.12 and SE=0.96, respectively. The 95%
confidence intervals run from -5.96 to -1.58 and -3.3 to 0.46, respectively (Table C). The wide
spread of these effect sizes reduces the reliability of the findings. Consequently, one could
consider these results a weak indicator of the magnitude of the link between economic growth
differential and expected exchange rate changes. To shed more light on this unclear relationship
we will incorporate economic growth in our hypothesis 2.

Effect sizes and confidence intervals for macroeconomic factors

Effect Size Lower Confidence level Upper Confidence Level

Lothian & Wu 1.13 - -

0.52 - -

Bansal & Dahlquist -3.78 -5.96 -1.58

-1.42 -3.3 0.46

Table C: outlines the effect sizes of the two papers that study the relationship between GDP growth and expected exchange rate changes.

Altogether, the precise effect of the discussed macroeconomic factors is ambiguous. While
logical reasoning provides ground to assume an influence of each of the three factors on
exchange rate differentials, research has not been able to establish supporting effect sizes for
any of the three factors. The considerable difference in slope coefficients for each factor as

20
well as the width of the CIs reinforces the question whether a universal formula for all exchange
rates can be found. Based on this scepticism, we will test for a more country specific effect of
commodity price changes on exchange rate changes.

Articles Related to Commodity Prices

Chan et al. (2009) consider 4 and Kohlscheen et al. (2016) research 12 major commodity
exporting countries. Both studies find a significant correlation between commodity prices and
exchange rate changes. While Chan et al. (2009) do not impose a causal relationship,
Kohlscheen et al. (2016) suggest commodity prices to be drivers of exchange rates. In this
respect, Chan et al. (2009) make inferences about general commodity indices and heavy
commodity exporters only. Kohlscheen et al. (2016) suggest an effect of the prices country
specific commodity indices on exchange rates, dependent on the magnitude of exports of a
certain country.

Chan et al. (2009) suggest a statistically significant correlation between the currency return of
a commodity-exporting country and broad as well as country specific commodity
indices. They do not report effect sizes but only the coefficient results of the granger causality
test, which are not directly comparable with any of the discussed effect sizes. Overall, a
drawback of the applied methodology seems to be that the authors took three diversified
commodity indices instead of linking individual commodities to specific countries.
Nevertheless, they conclude a heavy correlation between commodities and currency returns,
although they do not claim a causal relationship. Thus, in our hypothesis 3 we will consider
the impact of price changes of individual commodities on exchange rate changes.

Table D illustrates the slope coefficient values of the multiple linear regression model in
Kohlscheen et al. (2016). The paper assigns predictive power to commodity price changes and
thereby rejects the random walk theory. Although their effect sizes cannot be directly compared
to previous data, the authors proved that variables that are more sensible to a specific countrys
economy provide a higher predictive power than general economic factors. On a short- to
medium-term horizon (1-week up to 6-months) the paper concludes that the price changes of
commodities are stronger predictors of expected exchange rate changes than models based on
general economic factors, including interest rate differentials. By defining country specific
commodity indices that contain the 10 most exported commodities of each country,
Kohlscheen et al. (2016) find evidence of a distinct commodity related driver in currency return

21
changes. Overall, the values depict a low beta value span, ranging from 0.050 to 0.579 for
daily, 0 to 0.074 for weekly, and 0.016 to 0.244 for monthly time horizons. This consistent
trend of positive slope coefficients implies a positive correlation between commodity prices
and exchange rate fluctuations. However, many of the effect sizes are marginal. Furthermore,
the beta-values correspond to indices which makes it impossible to trace the effect sizes back
to individual commodities. Consequently, we intend to isolate and investigate individual
currencies as we presume more meaningfulness and higher effect sizes for individual
commodities.

Exchange rate predictability by commodities

Time horizon

1-day 1-week 1-month

AUD 0.579 0.091 0.074

CAD 0.287 0.014 0.057

NOK 0.180 0.001 0.074

BRL 0.445 0.074 0.244

CLP 0.190 0.058 0.027

COP 0.152 0.000 0.046

MXN 0.195 0.032 0.016

PEN 0.050 0.016 0.058

ZAR 0.158 0.015 0.033

RUB 0.277 0.050 0.170

MYR 0.067 0.005 0.041

Table D: Exchange rate predictability by commodities. Given currencies have been evaluated against the USD

After all, both papers suggest relevance of commodity prices in predicting exchange rate
fluctuations. Building upon the insights of the two papers, we will investigate the impact of
certain commodities on exchange rate changes. Contrary to the evaluated literature, we apply
a different criterion to select the commodities by using the 10 most traded commodities

22
worldwide. We examine their effect on the currencies of the 10 largest commodity exporters
as well as the 5 largest commodity importers, as we expect these countries to be most dependent
on commodity price fluctuations. However, we suspect that the currency return of the exporting
countries is considerably more affected by commodity price changes than those of importing
countries. This is reasonable to assume as exporters are more heavily dependent on only few
commodities, while importers often trade a larger variety of commodities.

Data & Methodology

The following second part of this paper is devoted to our own research. This study aims to
identify economic parameters that impact the change of exchange rates. Regarding managerial
relevance, a causal link could ideally allow them to predict exchange rate movements and
thereby reduce economic uncertainty. However, such causal relations can only be reliably
studied through experiments. As one cannot control financial markets or economic parameters
and simulations would not reflect actual reactions, an experiment is not feasible. Thus, this
study will resort to a panel research strategy, which cannot imply causality. Our strategy
examines a group of cases over a certain time frame. Specifically, this paper will conduct
multiple time-series studies. These time series studies will entail three linear regression models.
The findings will be reported in terms of beta coefficients, SEs as well as significance at a 95%
significance level and explanatory power (R). A more detailed outline of the methodology
applied during each hypothesis test follows the description of our dataset. Ideally, the panel
study will result in a data matrix that assigns effect sizes to each independent variable for each
case. A summary of all effect sizes can be found in Appendix C.

Dataset
In the following analysis, we try to evaluate the impact of various economic influencing factors
on exchange rate changes. As introduced before, there is no clear consensus in the available
literature whether certain factors help managers in forecasting changes in currency returns. To
shed light on the exchange rate puzzle, we construct a three-stage framework. By testing our
research question from three distinct perspectives, we aim to find certain patterns in the FX
market, which could help managers in making more certain currency investments and hedging
their international cash flows. The next section outlines the strategy and methods we used to
construct the dataset.

23
Population
Our research aims to determine the impact of various economic parameters and commodity
prices on the value of currencies. Thus, currency is the unit of interest and represents the focal
unit of this research. In this respect, the theoretical domain is comprised of all currencies in the
world, at all times. However, as this domain is highly heterogeneous, the population studied in
this paper will represent only a subset of the overall domain. Regarding the business context
of this paper, we prioritize the currencies that are most relevant to managerial decision making.
Furthermore, the availability of data dictates the feasibility of our research and restricts the
boundaries of our population. As a result, our population consists of all currencies traded on
the NYSE.

Sampling
Although it is desirable to find generally valid implications for all currencies in our population,
this study aims to provide an alternative perspective with country-specific managerial
implications. Past studies tried to derive implications for the whole population but failed in
providing conclusive managerial implications. We do not intend to statistically infer from
single cases to the whole population, but give managers guidelines that are relevant in
forecasting a specific exchange rate. Consequently, we suppose that it is not reasonable to apply
probability sampling, which would allow for generalization beyond the scope of single
countries. As we expect to find stronger effects for countries that are more heavily dependent
on certain commodities, purposive sampling seems appropriate. We examine the two biggest
exporters for each of the ten most-traded commodities as well as the five largest importing and
manufacturing countries. Lastly, the choice of sample is restricted by means of feasibility,
especially regarding the data availability. Even though most if not all exchange rate pairs are
traded publicly, long-term data is often not available, restricting the examinable sample.
Additionally, not all data is recorded and easily accessible through the databases that we can
access, which further restricts the sampling of this paper. The result is a sample of 14 countries.
Due to various reasons described in the remainder of this paper, three more countries are
excluded from this sample, resulting in a final dataset that consists of 11 exchange rates. The
exclusion of each of these three countries will be explained in detail during the following
sections.

24
Measurement
To test our three hypotheses, we construct a dataset that includes the following parameters for
the last 30 years:
Monthly and Quarterly spot exchange rates
Monthly and Quarterly interest rates
Economic data
o Quarterly current account data
o Quarterly inflation rates
o Quarterly GDP data
Monthly Commodity prices

We collected the data from electronic databases that are commonly used in financial research.
Each of the utilized databases is on the universitys list of accepted data sources and has been
proven to be valid and reliable. In the following we will elaborate which databases we utilized
for the extraction of data and how we establish its credibility. Furthermore, we will explain
how the obtained data is prepared to be useful in empirical analysis.

Since hypothesis 1 tests the effect of interest rate differentials on exchange rate changes, we
will begin with an outline of the data construction of these two variables.

Exchange rates
The monthly as well as quarterly spot exchange rates were obtained from Reuters Datastream.
Reuters is one of the largest and most renowned financial news agencies in the world.
Datastream is a broadly utilized database that is a widely known academic source of economic
data. Spot exchange rates are quoted live, as tradable on the FX market. Thus, they are
objectively determined by the markets and economic institutions and are not subject to
measurement error. Consequently, the data obtained from Datastream can be classified as valid
and reliable. Table E outlines the mnemonics for spot, 1-month, and 3-month forward rates that
we used to download the data. The table does not contain 1-month and 3-month forward rates
for the Chilean Peso and the Iranian Rial. Even after searching in Bloomberg, another
renowned provider of financial data, the two rates in question could not be found. Thus, we
decided to exclude Chile and Iran from our list of sampled countries. While this reduces our
sample size to twelve, we do not see any possibility to circumvent this shortcoming. This
drawback does not weigh heavily, as we do not intend to derive general implications for our

25
entire population. The exclusion simply prevents us from assisting managers that aim to hedge
against fluctuations in the Chilean Peso and Iranian Rial. As the EUR (Euro) only exists since
1999, we used the DEM (German Mark) from 1987 to 1999 instead. Although this might appear
misleading in the beginning, it is common practice in exchange rate research. A reason is that
the value of the EUR is a weighted average of the currencies of the twelve initial Eurozone
members, of which Germany was by far the strongest.

Mnemonics for Exchange Rate Data

Spot rate 1-month Forward rate 3-month Forward rate

Australian Dollar USD BBAUDSP* BBAUD1F* BBAUD3F*

Brazilian Real USD BRUSDSP* BRUS1MF* BRUS3MF*

Canadian Dollar USD BBCADSP* BBCAD1F* BBCAD3F*

Chilean Peso USD CHILPE$ - -

Chinese Renminbi USD CHUSDSP* USCNY1F* USCNY3F*

Euro USD EUDOLLR* EUDOL1F* BBEUR3F*

British Pound USD BBGBPSP BBGBP1F BBGBP3F

Indian Rupee USD INDRUP$* USINR1F* USINR3F*

Iranian Rial USD TDIRRSP - -

Japanese Yen USD BBJPYSP* BBJPY1F* BBJPY3F*

Mexican Peso USD MXUSDSP* USMXN1F* USMXN3F*

Russian Ruble USD RSUSDSP* USRUB1F* USRUB3F*

Saudi Arabian Riyal USD SAUDRI$* TDSAR1M* TDSAR3M*

South African Rand USD COMRAN$* BBZAR1F* BBZAR3F*

Table E: Mnemonics for exchange rate data. All mnemonics market with an asterisk (*) were subsequently reversed to bring them in the
following form: USD / respective currency

The spot rates are utilized to derive the month-on-month exchange rate changes according to
the following formula:

26
 "$7 "
"$7 = = ln "$7 ln " ,
"
where " represents the spot price of the foreign currency in units of the domestic currency at
time t.

Interest rates
The interest rates that we use in the empirical evaluation were not directly extracted from any
database, but calculated instead. As there are many ways to derive a fair approximation of
interest rates, we decided to calculate interest rate differentials based on the Covered Interest
Parity (CIP). This theory presumes no arbitrage between spot prices and forward contracts in
the FX market. The theory states that, as long as risk-free arbitrage is not present, the ratio
between forward and spot exchange rates equals the interest rate differential between countries
with similar characteristics (Chinn and Meredith 2004). This can be illustrated as
","$% 1 + ",%
= ,
" 1 + ",%
where ",% is the k-period interest rate (also called yield) in the domestic country and ",% is the
corresponding interest rate of the foreign country. Based on CIP, the interest rate differential
between two currencies can be calculated by subtracting the natural logarithm of the spot rate
from the natural logarithm of the forward rate. This step is illustrated by the following equation:
ln (","$% ) ln (" ) = (","$% ","$% ).

Economic Data
The second empirical analysis tests the relationship between differentials of general economic
factors between two countries and changes in the corresponding exchange rates. Concerning
the differentials of GDP growth, inflation rates, and current account changes, we take a similar
assumption as the UIP theory does. Specifically, we state that an increase in the inflation rate
differential positively influences the exchange rate, while a positive change in the differentials
of GDP growth and current account growth reversely impact exchange rates. We do not
presuppose a specific magnitude of the slope coefficients, as there are too many factors at play
that could falsify such supposition. The raw data of the economic parameters (current account,
inflation and GDP growth) were obtained from the OECD (Organisation for Economic Co-
operation and Development) database. OECD is an intergovernmental economic organization
comprised of 35 member countries that frequently reports economic parameters. As this
organization enjoys high reputation in the academic world and functions as an unbiased organ
27
that has gathered and analysed economic data for years, it is classified as reliable. Through its
online database at www.data.oecd.org we were able obtain the largest part of the economic
data. Only the data for Russia was not accessible, which we extracted separately from
Bloomberg. To make the raw data meaningful for our analysis, we use the following
modifications to derive the final variables necessary for the regression model.

Current account growth differential

We are interested in the current account growth differential between each of the twelve
countries and the USA. To get this variable, we first calculated the growth of each countrys
current account according to the following formula:
"$7 "
= "
"
where " represents the current account value of a country at quarter t. Afterwards, we
deducted the current account growth per quarter in the respective foreign country from the
current account growth per quarter in the US to get to the differential.

Inflation differential
The inflation differential between a currency and the US dollar in a certain quarter is the
difference between the inflation rates of the two countries in a certain quarter t.

GDP growth differential

The GDP growth differential in a certain quarter is obtained by subtracting a countrys GDP
growth from the US GDP growth.

Commodity Data
The third empirical analysis measures the statistical relationship between the change in
commodity prices and the change in exchange rates. For a matter of comparability, it includes
interest rate differentials as an additional independent variable. The commodity price data was
obtained from Reuters Datastream. We download monthly data for the ten most frequently
traded commodities. However, as different types of coffee depict high quality differences and
therefore do not conform to the general characteristics of a commodity, we exclude coffee from
our analysis. This leaves us with nine commodities as independent variables. The mnemonics
of the remaining nine commodities can be found in table F.

28
Since we are interested in the change in commodity prices, we modify the raw data for our
analysis by calculating the monthly change of a commoditys price at month t according to the
following formula:
"$7 "
= "
"

Mnemonics for Commodity Data

Commodity Mnemonics
Coffee -
Copper LCPCASH
Corn CORNUS2
Cotton COTTONM
Crude Oil OILBRNP
Gold GOLDBLN
Natural Gas NNGSM02
Silver SILVERH
Sugar WSUGDLY
Wheat WHEATSF
Table F: The Mnemonics we used to download the commodity price data from Reuters Datastream

Methodology
Having defined and calculated all required variables, we will now test our dataset for
multicollinearity, homoscedasticity, and outliers, before specifying the three regression
models. These three pre-tests are necessary requirements that need to be considered during the
empirical analysis to decide which type of regression can be applied.

Multicollinearity
Multicollinearity refers to the phenomenon that the independent variables are highly correlated
and can linearly predict each other with a substantial degree of accuracy. In the presence of
multicollinearity, the overall predictive power of the regression model would not be reduced.
However, multicollinearity limits the ability to extract the impact of individual predictors of
the dependent concept. In the first regression that tests UIP, multicollinearity is not an issue
because there is only a single predictive variable. Regarding regression two and three,
multicollinearity might pose an issue, as these regressions contain multiple independent
variables. Statistically, the independent variables would be perfectly multicollinear if a linear

29
relationship among them exists. This condition holds if we find the parameters 7 and ?
such that for all observations i we find
X?A = 7 + ? X7A .
This can be statistically tested by calculating the variance inflation factor (VIF), where the
tolerance is defined as:
7
tolerance = 1 R?J and VIF = ,
NOPQRSTUQ

with R?J being the coefficient of determination of predictor j. Generally, multicollinearity is

likely if VIF>3 and definitely exists if VIF>5. Running this with our dataset yields that
multicollinearity can be excluded.

Heteroscedasticity
Heteroscedasticity can be defined as a condition in which the variability of one variable is
unequal across the range of values of a second variable that predicts it (White, 1980). The
presence of heteroscedasticity in a dataset implies that the Gauss-Markov theorem cannot be
applied and that ordinary-least-squares estimators will not provide exact estimators of linearity.
This would ultimately imply that the regression model provides an unbiased estimate of the
relationship between the variables but that it will bias the estimates of standard errors. As a
result, heteroscedasticity is likely to lead to a type 2 error. The statistical test used to verify
whether heteroscedasticity applies to our dataset is the White test. H0 for this test states that
homoscedasticity, or no heteroscedasticity, exist. The standard linear regression model used in
this paper is
YA = X + 7 X7 + + T XA + A .
Whites equation for heteroscedasticity tests the relation of A with each of the independent
variables (XA ), the squares of the independent variables (XA? ) as well as all cross products of the
independent variables (XA XJ for i j). The result can be illustrated as:

YA = X + _ X A + _ XA? + _ XA XJ ,

where i represents a unique identifier of each independent variable and h is a consecutive

identifier of coefficient slopes. Based on this auxiliary regressions R value, we test the
models statistical significance of
?
nR? ~ Xab ,
where df defines the amount of regressors. The corresponding results imply that H0 is rejected
and heteroscedasticity is present in all samples.

30
White (1980) outlines that an OLS regression model can be used without concern of serious
distortion, as long as heteroscedasticity is not severe. Since this proposition represents a rather
vague guideline, we use the Newey-West standard error, which corrects for heteroscedasticity
and autocorrelation, in each of the following three regression models. Since Lag(0) is free of
autocorrelation, we can simply use Whites (1980) variance estimate formulation:

d = d X = ?i id i ,

i

where i = i i mno and i is the row I in the matrix X, n represents the number of
predictors at g observations. For any lag(m) where m>0, the Newey-West variance estimate is
applied:
v t
d
d = d X + 1 " "rs "d "rs + "rs ,
"
+1
su7 "us$7

where " represents the row in matrix X at time t (Newey and West 1987). We use twelve and
six lags for monthly and quarterly data, respectively, to corrected for autocorrelation and
heteroscedasticity. As a result, we can ensure that the least square residuals of each regression
model are consistent estimators of their slope coefficients.

Outliers
Considering that all data has been drawn from highly reliable and valid sources and exactly
reflects market data, we will not exclude any outlying data points from our models.

Regression Model 1: Uncovered Interest Parity

In our first model, we test the relationship between two countries interest rate differentials and
the expected change in the corresponding exchange rate, both monthly and quarterly. UIP states
that the interest rate differential between two countries equals the expected change in the
exchange rate. Consequently, H0 holds if the regression of the exchange rate on the interest
rate differential yields a slope coefficient equal to the value of unity ( = 1) and an intercept
of zero ( = 0). The implications of the UIP regression are outlined in Table G below.

The previously introduced risk-free arbitrage condition ","$% " = (","$% ","$% ) requires
adjustment, as the forward rate might entail a premium that compensates for the perceived risk
of holding domestic vs. foreign assets. Following, we derive the adjusted UIP proposition:

31
 5
","$% = ",% ",% ","$% ,
5
where ","$% represents the expected exchange rate change at date t+k and ","$% denotes the
risk premium implied in the forward rate to compensate for additional risk of holding the
foreign currency over the domestic currency. This equation implies that the expected change
in an exchange rate is equal to the interest differential of the respective countries. To define the
regression model, we assume that UIP is only operable when considering the assumption of
rational expectations in exchange markets as well as the proposition that the risk-premium is
zero (Chinn and Meredith, 2000). This means that we add a white-noise error term (","$% ) to
our model, which is not correlated with all known and implied information at time t:
5
","$% = ",% ",% ","$% + ","$% .
Consequently, the linear regression model to test the UIP hypothesis is:
5
","$% = + ",% ",% + ","$% .
This model follows both the UIP theorem and the efficient market hypothesis, as the
disturbance variable ","$% , reduces divergences regarding rational expectations.

Effect size requirements for UIP

(, + )
= () (, )
(: )
=1 > = 0 , = 0
<0 > , > () , < 0
>1 > , > () , < 0
=0.5 = ()
Table G: Four different cases of the beta coefficients in the UIP regression.

Regression Model 2: General Economic Factors

Having introduced the general model to test the UIP hypothesis, we continue with an outline
of the second regression model that measures the effects of general economic factor
differentials on expected exchange rate changes. The model follows the assumptions we made
for our first model. However, this model differs from the previously established UIP model in
that it contains multiple independent variables. In addition, our second regression model uses
only quarterly data instead of also monthly data. The attributes we rely on in this model are
GDP growth differential (7 ), inflation rate differential (? ), and current account growth
differential ( ). To illustrate how any of these factors can predict exchange rate changes

32

compared to UIP we also include the interest rate differential ",% ",% . The fundamental
assumption for our second regression model is a linear relationship, defined as

5
","$% = + 7 X7,N + ? X?,N + X,N + ",% ",% + ","$% ,

where is the intercept, represents the slope coefficients and ","$% defines the models error
term from quarter t plus k quarters to the next observation point. To estimate , we implement
a least squares analysis, by minimizing

5
A ","$% 7 XA,7 ? XA,? XA, ",% ",% ? ,

which requires
mno = X d X r7 X d Y,
where X d X r7 and XX are p + 1 (p + 1) symmetric matrices and X d Y is a
p + 1 dimensional vector (Williams, 2016). Then the fitted values are defined by
Y = X = X X d X r7 XY
and the residuals are
r = Y Y = I X X d X r7 X d Y.

The variance estimates are then calculated using Newey-Wests formulation for standard
errors, as outlined previously.

Regression Model 3: Commodity Currencies

In our third regression, we measure the relationship between 9 different commodities and
exchange rates. The estimation equation is a common multiple linear regression model based
on monthly commodity price changes as well as expected exchange rate changes. To compare
its explanatory strength with the results from the UIP regression, we also include interest rate
differentials as an additional independent variable. As we aim to derive country specific results,
we take the most traded commodities as individual independent variables. Including each
commodity separately instead of focused or diversified indices enables us to elaborate more
closely on the predictive strength of individual commodities. The resulting regression equation
is:
5
","$% =+ T PT,N + ",% ",% + ","$% ,
v

where PT,N represents the change in the commodity price of commodity type m at time t and
M denotes the total sum of all commodities included in the model. The OLS estimators as well
33
as residuals are calculated similarly as outlined above for regression model two, except that
model three includes 10 independent variables. Similar to the previous two models, the
variance estimates are calculated using the Newey-West standard error formulation.

Empirical Results
In this chapter, the results of our observations as well as the statistical analyses are discussed.
For each hypothesis, an overview is provided and the most striking outcomes are evaluated.

Hypothesis 1: Uncovered Interest Parity

At this point, our dataset consists of 12 currency-pairs, each with up to 360 measurement points
for the monthly horizon and around 100 when measured quarterly. The number of data points
depends on the availability of data for the different variables. Generally, we set our cut-off
point as April 1987 (30 years before the beginning of our empirical exercise) for all currencies.
Due to the multitude of measurement values, we opted to draw scatter plots instead of filling
in data matrices for the first hypothesis (Appendix B). These visualize the relationship between
the dependent variable (exchange rate changes; on the y-axis) and the independent variable
(interest rate differentials; on the x-axis) and can provide an initial indication about immediate
findings. After the discussion of the scatter plots we discuss the correlation and regression
(Table 2 & 3, Appendix C) outcomes for monthly and quarterly measurements separately,
before drawing a comparison between these horizons as well as with the existing literature.

While most scatter plots depict no noteworthy dispersion, we will discuss the most relevant
observations in the following. Firstly, Saudi Arabias exchange rate (Scatter Plot 11/23,
Appendix B) does not seem to fluctuate significantly, most data points are at 0 on the y-axis.
Upon further investigation, it becomes clear that this results from the Riyal being pegged to
the USD (Raghu, 2016). This means that its value changes together with the value of the dollar.
Thus, there is no change in the exchange rate between these currencies. Results regarding Saudi
Arabia are not representative and will be excluded in the following, as none of the variables
will be able to imply managerial relevance.

For most other scatter plots the data is spread out evenly around the 0 points of both x- and y-
axis. One exception is the scatter plot of Mexico (Scatter Plot 9/21, Appendix B), where most
data points are below the 0 of the x-axis, indicating a negative interest rate differential.
34
This outcome is similar for some other countries (e.g. Great Britain [Scatter Plot 6/18] or Russia
[Scatter Plot 10/22]), with the exception that for these countries more data points are situated
at a 0-interest rate differential on the x-axis rather than below 0. Similarly, most of Japans
(Scatter Plot 8/20) interest rate differential seem to be either at 0 or at 0.005, leading to a distinct
pattern that is worthy of further examination through regression.

Altogether, the Scatter Plots provide a first indication of the distribution of the data points.
Besides the exclusion of Saudi Arabia from our sample they do not allow for any further
judgment regarding managerial relevance. We will therefore focus on the regression outcomes,
discussing them for both monthly and quarterly measurements. The results for the specific
countries discussed in the following can be found in Table H below.

Monthly Data
For the monthly measurements (Table 2, Appendix C), 6 of the unstandardized regression
coefficients are negative and 5 are positive. Of these 5 positive effect sizes, 3 are closer to the
value of unity than to zero, and two are significantly so, at a 95% confidence level (China,
Russia). As these can be considered the most relevant support of our hypothesis 1, they will be
discussed in more detail and can be found in Table H below.

For China, an unstandardized regression coefficient of 0.647 (N-W SE: 0.171) was obtained.
It is the second highest effect size in the sample, and its correlation coefficient is also the second
highest with a value of 0.351. Even though these values do not coincide with the value of unity
as predicted by UIP, they do not suggest to reject the UIP-hypothesis. More specifically, the
unstandardized effect size means that an increase of 1pp in Chinas interest rate opposed to the
US-interest rate is followed by a decrease of 0.647pp in its exchange rate with the USD. The
models explanatory power, as described by the adjusted R, is 0.118. This means that 11.8%
of the variation in the exchange rate change of the CNY/USD (Chinese Yuan Renminbi) can
be explained by the interest rate differentials. While 11.8% is a sizable value, it gives rise to
the assumption that the interest rate is not the only influencer of exchange rate fluctuation of
the CNY/USD. This finding substantiates the importance of this study, as there seems to be the
necessity of finding a model that can better predict exchange rate changes than the UIP.

Similarly, the test for the RUB/USD (Russian Ruble) yields an unstandardized effect size of
1.203 (N-W SE: 0.243), the highest value observed. This value implies a decrease of 1.203pp
35
in the RUB/USD exchange rate upon a 1pp increase in Russias interest rate compared to the
US-interest rate. The correlation coefficient equals 0.413, which represents the highest value
in the sample. The same is true for the models explanatory power, 16.5% of the variation in
the change in exchange rate of the RUB can be explained by the interest rate differentials.
While the interest rate seems to represent a slightly better explanatory parameter in the case of
Russia than in the case of China, both values suggest the presence of additional explanatory
factors of exchange rate changes.

In contrast, the MXN (Mexican Peso) has the lowest unstandardized regression coefficient with
-0.580 (N-W SE: 0.260). The correlation remains negative but less so (-0.124). This regression
model, however, has an adjusted R of 0.011, thus for the MXN/USD only 1.1% of the
variability in exchange rate changes can be explained by interest rate changes. While the
previously discussed results suggest additional independent factors besides the interest rate
differential, this finding questions the impact of interest rate differentials in its entirety. As all
other countries models have a low explanatory power close to 0, they will not be discussed in
further detail. Their results, however, can be obtained from Table 2 in Appendix C.

Quarterly Data
Regarding the quarterly results (Table 3, Appendix C), 5 of the unstandardized regression
coefficients are negative, with one being only marginally so. Again 6 unstandardized effect
sizes are positive, two significantly so at the 95% significance level. However, only the effect
size for CNY (Chinese Yuan Renminbi) is closer to the value of unity than to zero. The
currencys unstandardized effect size is 0.758 (N-W SE: 0.216). While it does not fully support
the UIP hypothesis, this result supports the claim of a sizable impact of interest rates on
exchange rate fluctuation. Specifically, this result suggests that a 1pp increase in the Chinese
interest rate, as compared to the US interest rate, is followed by a 0.758pp decrease in the
corresponding exchange rate. The correlation coefficient is 0.487, a value that is significant at
the 99% significance level (2-tailed). Furthermore, the described model has an adjusted R of
0.224, which implies that in the case of China the interest rate differential can explain 22.4%
of the variation in exchange rate changes with the USD.

Another correlation that is significant at the 99% significance level (2-tailed) is ZAR/USD
(South African Rand). The countrys unstandardized regression coefficient is positive but low
at 0.106 (N-W SE: 0.045), but significantly different from 0 at the 95% significance level.
36
Having an adjusted R of 0.075 the countrys model also has the second highest explanatory
power.

The lowest unstandardized regression coefficient is found for the AUD (Australian Dollar)
with -1.095 (N-W SE: 2.158). When standardized, it remains negative at -0.068. The adjusted
R, however, is also marginal and even negative (-0.007). Once again, as most other countries
models have similarly low explanatory power, these will not be discussed in further detail but
can be found in Table 3, Appendix C.

Key results of hypothesis 1 with monthly and quarterly data

Country Measurement Correlation Reg. Co. Unstd. N-W SE Significance Adj. R
period 12 & 6 lags
Australia Monthly -.003 -.056 1.309 .966 -.004
Quarterly -.068 -1.095 .2.158 .613 -.007
China Monthly .351 .647 .171 .000 .118
Quarterly .487 .758 .216 .001 .224
Mexico Monthly -.124 -.580 .260 .027 .011
Quarterly -.126 -.435 .259 .097 .004
Russia Monthly .413 1.203 .243 .000 .165
Quarterly .042 .130 .396 .744 -.018
South Africa Monthly .144 .031 .014 .027 .017
Quarterly .291 .106 .045 .019 .075
Table H: Discussed results Hypothesis 1

Comparing our results to other studies, one can conclude that our values are generally in line
with previous findings. While some of our regressions provide supporting evidence, the
majority of our observed currencies do not support the UIP theorem. Even more so, both the
monthly and quarterly data provide evidence of contrasting effect sizes closer to -1 than to the
value of unity. The same is the case for Flood and Rose (2001) and Bansal and Dahlquist
(2000), who tested UIP on a similar horizon and who also measured monthly. Compared to
long horizon results measured monthly by Chinn and Meredith (2004), Mehl and Cappiello
(2007), and Lothian & Wu (2011), our data gives significantly less support for UIP. The same
is the case when comparing our results to the overnight UIP tests as performed by Chaboud
and Wright (2005). Regarding managerial evidence, both, this part of our study and previous
research, are not able to give clear indications. The results of the countries differ greatly, and
most models possess a low explanatory power. Only over extremely short or long horizons

37
there seems to be support for UIP, but this does not provide utility to managers. Further, in our
study the results of the monthly and quarterly regressions differ widely. This ambiguity in
findings in our study as well as other papers implies the necessity to search for other factors
that impact exchange rate changes. Thus, we aim to find new models with higher explanatory
power by adding other variables in the next sections, starting with the macroeconomic factors
of hypothesis 2.

Hypothesis 2: General Economic Factors

Table 4 in Appendix C presents a summary of the impact of a countrys economic
characteristics (interest rate, current account growth, inflation, and GDP growth) on the
respective countrys USD exchange rate. The table presents the 11 sampled countries whose
economic parameters are measured on a quarterly basis. Linear regression lets us identify the
unstandardized regression coefficients of each parameter as well as their significance values.
The adjusted R presents evidence on how much of the variation of change in exchange rate
can be attributed to the combination of the four factors.

Overall, the regressions show that none of the additional economic factors (current account
growth differential, inflation differential, GDP growth differential) seem to impact the
exchange rate considerably. The unstandardized regression coefficients that indicate the impact
of a 1pp change in either of the three parameters on the exchange rate are close to zero for all
countries across all three factors. Compared to the unstandardized regression coefficient of the
interest rate differentials the other three factors have a marginal influence. While interest rates
seem to potentially have an impact on exchange rate changes, the three additional parameters
seem to have no additional value. The results for the specific countries discussed in the
following can be found in Table I below.

Regarding the current account growth differential, coefficients are both marginally positive
and negative. Even the largest coefficients of the current account growth differential in absolute
terms, namely of the AUD (Australian Dollar) with -0.038 (N-W SE: 0.022) and of the RUB
(Russian Ruble) with -0.016 (N-W SE: 0.016), are negligible. Thus, the current account growth
differential does not depict any noteworthy influence on exchange rate changes, and hence
does not present useful assistance for managers in their attempt to predict exchange rate
changes.

38
Similarly, the inflation differential does not represent more than a marginal influence on
exchange rate changes. The absolute values of almost all coefficients are smaller than 0.01.
Only the coefficient of the EUR (Euro) depicts a slightly larger value in absolute terms, -0.027
(N-W SE: 0.007). This finding is interesting as the inflation rate has fluctuated significantly in
the Euro zone, particularly throughout the last 10 years. Nevertheless, the value does not appear
large enough to provide a useful input regarding the prediction of exchange rates and thus
managerial relevance. Altogether, the inflation rate differentials do not have a considerable
effect on exchange rate fluctuations and can thus not aid managers in their efforts to predict
exchange rates.

The third parameter, GDP growth differential, also does not appear to influence exchange rate
changes significantly. As with the other two parameters, all unstandardized regression
coefficients are distributed closely around zero, with some being marginally positive and others
marginally negative. We can observe the largest coefficients in absolute terms for the RUB
(Russian Ruble) with 0.023 (N-W SE: 0.014) and the AUD (Australian Dollar) with 0.019 (N-
W SE: 0.014). These values are not only small but they are also contrasting our intuitive
judgement that a higher GDP growth would lead to an appreciation of the respective countrys
currency. Consequently, we conclude that GDP growth differentials are no suitable mean to
estimate exchange rates. Thus, the observation of GDP growth of certain countries does not
provide managers with relevant information to predict exchange rate fluctuations.

Key Results of hypothesis 2 with quarterly data

Country Variable Reg. Co. Unstd. N-W SE (6 lags) Significance Adj. R
Australia Interest rate diff. -.454 2.400 .836 .033
Current Acc. diff. -.038 .022 .123
Inflation diff. -.010 .008 .203
GDP Growth diff. .019 .014 .217
Euro Zone Interest rate diff. .892 2.439 .713 .088
Current Acc. diff. -.001 .001 .416
Inflation diff. -.027 .007 .000
GDP Growth diff. -.013 .012 .292
Russia Interest rate diff. -.072 .608 .880 -.020
Current Acc. diff. -.016 .016 .422
Inflation diff. .003 .004 .417
GDP Growth diff. .023 .014 .159
Table I: Discussed results Hypothesis 2

39
The previous discussion suggests that neither of the three economic parameters has any sizable
effect on exchange rate changes. These conclusions are contrasting the corresponding findings
in our critical synthesis. Concerning the current account differential, Dornbusch and Fischer
(1980) hypothesize that a comparably favorable current account differential should positively
impact the exchange rate of a country. Our data cannot support this reasoning that has simply
been of theoretical nature. Regarding the impact of inflation rate differentials, Flood and Rose
(2001) as well as Bansal and Dahlquist (2000) found a sizable positive effect size within their
population of developed and developing countries. Our data does not support these findings
but suggests no significant impact. Economic growth has been established as a potential
influencer of exchange rate changes by Lothian and Wu (2011) and Bansal and Dahlquist
(2000). However, they find opposing results as Lothian and Wu (2011) find positive effect
sizes, while Bansal and Dahlquist (2000) find negative effect sizes. Our data cannot resolve the
ambiguity as we find only marginally positive and negative effect sizes.

Based on the previous discussion, we conclude that changes in the current account growth
differential, inflation differential and GDP growth differential between two countries do not
have a significant impact on changes in the exchange rate between the respective countries.

Hypothesis 3: Commodity Currencies

Having proven that neither of the tested economic factors can be used as a universal predictor
of exchange rate changes, we now take a different approach as we will focus on more country-
specific combinations of factors. Specifically, we regress monthly changes of the future prices
of 9 commodities on the exchange rates of countries that are either large exporters or importers
of at least one of these commodities. Thereby, we show that commodity prices have a stronger
predictive power than the previously tested indicators in hypothesis 2. Furthermore, we will
establish the notion that certain commodity prices are a valuable addition to interest rates as
predictors of exchange rate changes. Here, one must remark that this commodity based
forecasting factor is country specific and not universal. Every country has a specific
combination of commodity prices that its economy and its currency price is subject to. We first
demonstrate that correlations between certain country specific commodities and exchange rates
are generally higher than the predominant economic factors such as GDP growth, current
account growth, or inflation rate. Thereafter, we regress each of the 11 exchange rates on the

40
prices of the 9 most dominant commodities and illustrate which of these commodities serve as
the strongest predictors for each exchange rate.

Table J illustrates the correlations of each exchange rate to commodity prices as well as the
respective interest rate differential. Strikingly, only one of the twelve analyzed exchange rates
(Chinese Renminbi to US Dollar) appears to be somewhat correlated with its interest rate
differential (r=0.315). In return, the other eleven exchange rates show a considerably stronger
correlation to either one or several of the included commodities. As already hypothesized, the
strength of each commoditys correlation differs across exchange rates, underlining our
presumption that a country-specific analysis will yield a stronger predictive power than the
previous two regressions. Countries that are large exporters of certain commodities mostly
show a strong correlation between its exchange rate and the respective commodity. For
example, it appears that the INR (Indian Rupee) gains in strength when prices of oil or silver
rise, which both belong to the most exported products of the country. Also, the BRL (Brazilian
Real) seems to be highly correlated with price changes in Oil (r=0.248), Sugar Cane (r=0.233),
and Copper (r=0.288), three products that amount to 13% of Brazils total exports, namely
making up $26 billion (Atlas.media.mit.edu, 2017). Interestingly, for Russia, where one would
expect an above average correlation between the exchange rate and the oil price, we find a
coefficient of r=0.081 only. An explanation for this striking finding could be that the USD (US
Dollar) gains in strength by approximately the same rate as the RUB (Russian Ruble) when oil
prices increase, thus keeping the exchange rate flat. Regarding importing countries in our
sample we find that the Gold price is positively correlated to multiple exchange rates
(EUR/USD: r=0.339, GBP/USD: r=0.252, JPN/USD: r=0.294). This observation could be
explained by the fact that the price of Gold has a strong negative correlation with the value of
the USD (Samanta & Zandeh, 2012). Although this evaluation does not help in estimating the
predictive strength of commodity prices, it clearly suggests co-movement trends between
currencies and commodities.

Table 5, Appendix C reports the results of the regression for the entire sample. We find that
the model reports higher adjusted coefficients of determination (R2) for all expected changes
in exchange rates (except for CNY) than any of the previous models. The results for the specific
countries discussed in the following can be found in Table K below.

41
 Pearson Correlations
EUR/ CAN/ GBP/ JPN/ INR/ CNY/ SAR/ RUS/ BRL/ MXN/ AUD/ ZAR/
USD USD USD USD USD USD USD USD USD USD USD USD
Interest R.
Differential -0.033 0.009 0.032 -0.038 0.009 0.315 0.018 0.108 -0.076 -0.128 -0.003 0.144
Oil 0.146 -0.346 0.182 0.088 0.164 0.228 0.180 0.081 0.248 0.179 0.325 0.192
Gas 0.082 -0.199 0.083 0.008 0.003 0.005 -0.003 -0.021 -0.013 0.089 0.152 0.007
Gold 0.339 -0.202 0.252 0.294 0.072 0.161 0.074 0.006 0.078 -0.052 0.282 0.001
Wheat 0.022 -0.092 0.063 -0.002 0.115 0.028 -0.017 -0.012 0.178 0.090 0.181 0.076
Cotton 0.128 -0.181 0.105 0.021 0.121 0.045 0.048 0.069 0.167 0.004 0.092 0.077
Corn 0.070 -0.132 0.067 -0.010 0.046 0.128 -0.002 0.021 0.026 0.055 0.095 0.042
Sugar 0.046 -0.115 0.020 0.042 0.002 0.081 -0.009 -0.004 0.233 0.070 0.108 0.086
Silver 0.161 -0.305 0.120 0.113 0.152 0.107 0.073 -0.019 0.203 0.075 0.388 0.059
Copper 0.232 -0.366 0.271 0.065 0.080 0.082 0.053 0.156 0.288 0.200 0.469 0.148

Table J: The Pearson Correlation coefficients of each of the dependent variables against the ten independent variables.

Regarding effect sizes, Australia and Brazil provide evidence of the exchange rate dependency
on the price movements of heavily traded commodities. The countries strongest export
commodities show the highest beta coefficients. For Australia, the three strongest predictors of
expected exchange rate movements are the Oil price (=0.054; N-W SE: 0.012), the Silver
price (=0.082; N-W SE: 0.029) and the Copper price (=0.132; N-W SE: 0.037). In line with
our proposition, this result appears reasonable as Australia is known for its mining industry,
which consists to a considerable part of Silver and Copper. Furthermore, Australia heavily
exported oil with a value of $12.7 billion in 2016 (representing 6.7% of its total exports)
(Atlas.media.mit.edu, 2017). All in all, the model for Australia is a strong proponent of our
framework with a coefficient of determination of 29.6%. Compared to the model one and two,
the commodity model is able to predict 29.6pp and 23.3pp, respectively, more of the variance
of the AUD exchange rate with the USD.

The case for the BRL (Brazilian Real) is similar. Model three allows us to explain about 20pp
more of the variance in BRL/USD than either of the first two models that relied on economic
factors alone. The strongest positive beta coefficients are Silver (=0.194; N-W SE: 0.061) and
Sugar Cane (=0.175; N-W SE: 0.042), while the beta of Gold is the strongest negative value
equaling -0.248 (N-W SE: 0.146). The high beta level of the price of Silver is surprising due
to the inability to justify it by market data of either exports or imports. One possible explanation
could be the inverse relationship of the USD to the price of Silver (Kowalski, 2017). On the

42
contrary, the coefficient of Sugar Cane appears to be in line with our hypothesis, since it is
Brazils 3rd largest export product (Atlas.media.mit.edu, 2017). Considering that the USD is
inversely correlated with the Gold price, it is striking that the model yielded a negative beta
coefficient, meaning that the Brazilian Peso appears to be even more negatively related to the
price of Gold than the US Dollar.

The RUB (Russian Ruble) yields the highest R2 result, where commodity prices and the interest
rate differential predicted 33.3% of the variance in exchange rate changes. This R2 value is
16.8pp larger than the coefficient of determination in the UIP regression model. The interest
rate differential and changes in the oil price show the highest beta coefficients of 1.201 (N-W
SE: 0.199) and 0.160 (N-W SE: 0.056), respectively. Since in total 46% of Russias exports is
represented by oil, this result suggests that our model cannot be applied to every country that
heavily exports one single commodity (Atlas.media.mit.edu, 2017).

As already investigated in the correlation analysis above, those countries with a strong
manufacturing industry and a negative trade balance show high beta coefficients for the price
of Gold. For the EUR/USD sample, the coefficient is =0.238 (N-W SE: 0.040), while for the
GBP/USD and JPY/USD sample the value is =0.158 (N-W SE: 0.034) and =0.260 (N-W
SE: 0.060), respectively. As suggested above, this finding might be explained by the USDs
strong negative correlation with the Gold price, which weakens its value and consequently
increases each of the three exchange rate pairs. For Japan, neither the interest rate differential
nor any other commodity shows any noteworthy coefficient of correlation. However, for the
EU and for Great Britain especially, it is worth noticing that the beta coefficients of Copper
could give managers an idea about future tendencies in exchange rates. The regression found
coefficients of =0.059 (N-W SE: 0.017) for EUR/USD and =0.078 (N-W SE: 0.020) for
GBP/USD. Although only 0.33% of the UKs exports consist of Copper, this finding can be
justified by the fact that five of the ten largest Copper producers are either headquartered in the
UK or are majorly owned by British companies (Atlas.media.mit.edu, 2017) (Barrera 2017).

Applying regression model three to the changes of the CNY/USD (Chinese Yuan Renminbi)
yields another striking result. The worlds fastest growing economy does not seem to be
influenced by the price changes of a specific commodity. While, China exported almost twice
as much as it imported in 2016, there is a very important aspect hidden in the data
(Atlas.media.mit.edu, 2017). Out of the $2.73 trillion exports in 2016, only about 9% or $245.5
43
billion can be attributed to commodities while about 62% of all imports are commodities
($787.4 billion), making China a commodity importer rather than exporter
(Atlas.media.mit.edu, 2017). These findings are in line with our previous argumentation that
importers are considerably less influenced by commodity price changes.

Key results for hypothesis 3 with monthly data

Country Variable Reg. Co. unstd. N-W SE (12 lags) Significance Adj. R
Australia Interest rate diff. .039 1.010 .969 .296
Oil price change .054 .012 .047
Gas price change .017 .012 .155
Gold price change .009 .080 .913
Wheat price change .017 .022 .446
Cotton price change .024 .023 .303
Corn price change .026 .021 .237
Sugar price change .015 .015 .337
Silver price change .082 .029 .007
Copper price change .132 .037 .000
Brazil Interest rate diff. -.024 .138 .865 .203
Oil price change .044 .039 .260
Gas price change -.021 .018 .261
Gold price change -.248 .146 .043
Wheat price change .042 .029 .161
Cotton price change .044 .041 .282
Corn price change .029 .031 .361
Sugar price change .175 .042 .483
Silver price change .194 .061 .002
Copper price change .107 .040 .009
China Interest rate diff. .553 .205 .000 .156
Oil price change .014 .007 .040
Gas price change -.004 .003 .367
Gold price change .022 .014 .014
Wheat price change 9.180E-6 .003 .661
Cotton price change -.001 .003 .544
Corn price change .004 .003 .153
Sugar price change .002 .004 .714
Silver price change -.007 .007 .289
Copper price change -.007 .005 .186
Russia Interest rate diff. 1.201 .199 .012 .333
Oil price change .160 .056 .049

44
 Gas price change -.021 .016 .625
Gold price change .035 .057 .293
Wheat price change -.030 .028 .234
Cotton price change .030 .028 .829
Corn price change -.004 .029 .874
Sugar price change -.001 .019 .578
Silver price change -.011 .037 .581
Copper price change .048 .032 .355
Table K: Discussed results Hypothesis 3

The empirical findings from the third regression model match the results from previous
research by Chan et al. (2009) as well as Ferraro, Rogoff and Rossi (2012) and Kohlscheen et
al. (2016). Each of the papers formulates a comparable regression model and concludes a
predictive power of certain commodities or commodity indices for countries that are large
exporters of commodities. In our model, especially the AUD/USD and BRL/USD depict
considerable dependence on the prices of individual commodities. In these cases, we suggest a
relationship between commodity price changes and exchange rate changes, as the respective
commodities represent significant portions of the countries exports. Overall, the values
underline our initial assumption that particularly exporters currencies are considerably
affected by the prices of their major exported goods. Further, the marginal coefficients of the
Chinese Renminbi support our initial suggestion of a negligible impact of commodity prices
on the currency of countries that mainly import commodities. In addition, we obtained similar
findings as Chan et al. (2009) for the ZAR (South African Rand), which appears to be an
exception to our hypothesis 3 as commodities do not yield any predictive power in this case.
Overall, however, even though this hypothesis is barely researched it appears to hold
considerably more predictive power on a countrys expected exchange rate change than any
general economic factor. Further, it seems that the example of commodities proves that a
country specific approach to forecast exchange rate changes is more promising than a universal
formula.

Robustness Test
In the previous section, we found that on average the beta coefficients of commodity price
changes in hypothesis 3 have a higher predictive power on exchange rate changes than the
tested economic factors in hypotheses 2. Furthermore, we proposed to consider commodity
prices changes as an additional influencer of exchange rate changes next to interest rate
45
differentials. To verify the correctness of our test findings, we perform a robustness test of our
hypothesis 3. Testing the sensitivity of our findings is essential because exchange rates are
exposed to an extremely fast paced and complex environment, which might distort any
forecasting effect found in the regression. Testing the robustness helps us make a clear and
valid conclusion of our findings and provides new insights into the overall predictive power of
commodity prices.

In the previous empirical tests, we used exchange rates based on the bilateral base currency
USD. In order to validate that the results from the regression model three are not driven by
correlations between the USD and the commodity prices, but rather due to the price changes
of commodities themselves, we change the base currency to GBP (British Pound Sterling) and
run another regression model. In this, the 10 new spot exchange rates have been downloaded
from Datastream. Contrary to our initial regression model three, we do not include interest rate
differentials and fully focus the measurement on commodity price changes. The main reason
for this change is the fact that forward rates between the GBP and the 10 counter currencies
are not available for the 30-year time frame for all instances. Thereby, we are not able to
calculate the interest rate in the same way as in the regression against the USD exchange rates.

Table K shows the most striking results, while Table 6 in Appendix D outlines the direct
comparison of the results for all currency pairs based on the two different home currencies and
as well as the same nine commodities used before. Overall, the effect sizes in the GBP
regressions are only marginally weaker than in the case where the USD is the base currency.
One reason of the slight decrease in most beta coefficients could be the fact that all commodity
prices are denominated in USD. Hence, a change in the return of the USD would naturally lead
to a change in the USD denominated price of the commodities. In his research on the
relationship between commodity prices Akram (2009) found a generally strong negative
correlation concerning US dollar return and the price of 5 commodities used in our research
(oil, gas, gold, silver, corn). Despite the reduction in overall effect, the results of the robustness
test outperform the random walk theory for all 10 exchange rates. Specifically, for each
currency pair at least one beta coefficient value is above .14 (all except two significantly so).
A striking finding is that all slope coefficients for Gold changed significantly. While the
EUR/USD depicted a beta for gold of 0.239, the EUR/GBP has a beta value of 0.142. A
potential explanation for this difference between the two regression models is the strong
negative correlation between the USD and the Gold price. A similar picture can be drawn when
46
considering the Mexican Peso as counter currency. The beta coefficients change from =-0.185
for MXN/USD to 0.341 for MXN/GBP. These significant changes in the predictive power of
the gold price clearly show that the USD is not an optimal base currency for our assumption,
as its correlations with commodity prices strongly affects the regression results.

On the contrary, a similar limitation is the British Pounds positive correlation with the price
of Silver. When taking USD as the base currency, we only find 1 coefficient of silver prices
that can give managers an indication about an expected exchange rate movement. However,
when taking GBP as the base currency we find 5 out of 10 beta coefficients smaller than -.1,
indicating that the exchange rate weakens when the price of silver increases. For CAN/GBP,
for example, we find =-0.104 (CAN/USD =0.055) and for ZAR/GBP we find a beta of -
0.147 (ZAR/USD =0.023). This is a clear indicator that managers should first check for the
correlations between the base country and commodity prices before making inferences about
the predictive strength of commodity price changes on exchange rate changes.

Robustness Test Regression with monthly data

USD GBP

Reg. Co. N-W SE Significan Reg. Co. N-W SE Significan

unstd (12 lags) ce unstd (12 lags) ce
Country Variable
Canada Oil-Price -.035 .013 .011 .108 .017 .000
Gas-Price -.018 .005 .002 .013 .011 .240
Gold-Price .012 .039 .479 .171 .045 .000
Wheat-Price -.001 .010 .903 -.002 .018 .900
Cotton-Price -.023 .014 .129 -.001 .019 .969
Corn-Price -.012 .015 .447 -.003 .025 .916
Sugar-Price .008 .009 .403 -.001 .021 .960
Silver-Price .055 .017 .002 -.104 .029 .001
Copper-Price -.070 .017 .000 .005 .018 .783
Euro Oil-Price .013 .016 .424 .029 .041 .479
Zone Gas-Price .007 .010 .502 .009 .013 .516
Gold-Price .239 .039 .000 .142 .068 .004
Wheat-Price -.018 .015 .235 .001 .022 .947
Cotton-Price .040 .019 .046 .012 .029 .695
Corn-Price .025 .020 .223 .004 .024 .857
Sugar-Price -.006 .014 .659 -.010 .014 .466

47
 Silver-Price -.060 .028 .040 -.050 .054 .359
Copper-Price .058 .018 .002 .049 .029 .102
Mexico Oil-Price .047 .017 .008 -.030 .028 .294
Gas-Price .021 .023 .387 -.024 .029 .400
Gold-Price -.185 .078 .018 .341 .087 .000
Wheat-Price .033 .026 .213 -.033 .030 .280
Cotton-Price -.032 .042 .455 .048 .041 .254
Corn-Price -.004 .012 .861 .012 .032 .699
Sugar-Price .005 .031 .867 .000 .036 .989
Silver-Price .070 .029 .020 -.101 .037 .008
Copper-Price .105 .037 .018 .162 .031 .607
Russia Oil-Price .219 .046 .677 .348 .067 .000
Gas-Price -.024 .022 .288 .012 .022 .590
Gold-Price -.119 .119 .322 .301 .165 .051
Wheat-Price -.042 .043 .325 .078 .039 .047
Cotton-Price .012 .044 .787 -.013 .033 .694
Corn-Price .091 .053 .080 -.038 .049 .440
Sugar-Price .081 .082 .325 -.129 .114 .259
Silver-Price .046 .069 .511 -.138 .105 .193
Copper-Price .131 .063 .040 .017 .040 .682
South Oil-Price .067 .035 .058 -.017 .023 .470
Africa Gas-Price -.010 .019 .608 .000 .008 .976
Gold-Price -.073 .066 .273 .095 .0115 .011
Wheat-Price .026 .021 .235 .015 .059 .543
Cotton-Price .013 .038 .742 .000 .024 .999
Corn-Price -.011 .028 .696 .011 .031 .674
Sugar-Price .017 .026 .529 -.014 .026 .731
Silver-Price .023 .039 .561 -.147 .030 .000
Copper-Price .043 .053 .425 -.002 .037 .903
Table L: Results of the Robustness Test regression in direct comparison with results from regression of hypothesis 3. The interest rate
differential has been excluded from this test due to the inability to retrieve reliable forward rates for some currencies against the GBP.

Overall, the robustness test shows that our assumption of using changes in commodity prices
as predictive indicators for exchange rates is valid. However, one must carefully consider the
correlations between the base currency and commodities in order to come to clear and valid
conclusions. In addition, the test also found that using the USD as base currency is not optimal,
as the effect sizes of gold and oil seem to correlate heavily with the return of the USD.

48
 Conclusion & Implications for Practice
This paper aimed to provide a framework that can assist managers in hedging currency risk.
Globalization has exposed a wide array of businesses from various countries to international
risk. In line with this development, managers find themselves subject to increasing pressure to
hedge their cash flows and reduce their currency exposure. In this respect, a comprehensive
framework that can predict exchange rate changes would reduce uncertainty and would
increase the competitive position of any internationally operating business. Against this
background, we set out to explain exchange rate changes by testing 3 different hypotheses. We
examined the highly criticized UIP theory followed by a test of three other economic factors
that could theoretically impact exchange rate changes. Lastly, we checked for a country-
specific influence of commodity price changes on exchange rate changes of the currencies of
countries that are highly engaged in international trade.

Regarding the UIP hypothesis, our research substantiates the skepticism of other research in
the field. Both our monthly as well as our quarterly results do not find support for UIP. On the
contrary, most effect sizes suggest to reject the UIP framework. These findings are in line with
the research of Flood and Rose (2001) and Bansal and Dahlquist (2000). Particularly striking
is the inconsistency of the effect sizes. Oftentimes the monthly effect size of one currency pair
provided contradicting implications compared to the quarterly results of the same currency
pair. After all, we conclude that UIP does not hold and that interest rate differentials can at best
partially explain exchange rate fluctuations. Managers in the global environment will thus need
to look out for other influencers in order to be able to actively hedge against unfavorable
exchange rate fluctuations.

With regard to the other economic factors that we tested the predictive effect was found to be
marginal. Dornbusch and Fischer (1980), Ito et al. (1999) and Bansal and Dahlquist (1998)
suggest an influence of current account growth differential, inflation differential and GDP
growth differential, respectively. Our results could not substantiate any of their findings. On
the contrary, all three economic factors reveal negligible effect sizes. Thus, we conclude that
the three economic factors cannot assist managers in their attempt to hedge their international
financial position by forecasting exchange rate changes.

49
In testing our last hypothesis, we found evidence of commodity prices as predictors of
exchange rate changes. In line with Chan et al. (2009) and Kohlscheen et al. (2016) we
established that currencies are to some extent correlated with specific commodity prices. Based
on our effect sizes we conclude a sizable correlation between commodity price changes and
exchange rate changes. This link is expected to hold, especially for commodity exporters. In
our dataset, this hypothesis is particularly substantiated by the effect sizes of the Brazilian Real
and the Australian Dollar, which considerably depend on the prices of sugar cane, and copper
and silver, respectively. While this relationship is not observable for every country in our
sample, the effect sizes suggest a higher impact of commodity price changes on exchange rate
changes than the other economic factors tested in hypothesis 2. In this respect, commodity
prices could represent a valuable addition to all models that attempt to explain exchange rate
changes solely through interest rate changes.

Regarding the dilemma of international managers, the previous conclusions can provide
precious insights. Generally, our findings reinforce the hypothesis that interest rates represent
at best one out of many parameters that can assist managers in hedging their currency risk.
More specifically, our findings emphasize that exporters should closely monitor price
movements of the most heavily exported commodities of their home country. Managers of
importing businesses are affected by the implication of our results as well. We suggest that
they should watch prices of the biggest export commodities of their trade partners home
countries. Otherwise managers could, for instance, be surprised by foreign denominated
payables that translate into increasing home country denominated expenses. After all, this
paper should encourage managers to look beyond the UIP theory in their attempt to hedge their
currency risk. While commodity prices do not solve the entire puzzle, they do add another piece
to the exchange rate picture.

Limitations & Further Research

Our study is subject to several limitations that we were not able to circumvent.
Firstly, our research strategy, the panel study, does not allow us to imply causality. As
described above, only an experiment can describe such an effect confidently. However, a panel
study was the only viable research strategy, thus we were only able to argue theoretically based
upon our regression results. Even though this methodology is common practice in

50
macroeconomic research it remains a drawback of our study, as we cannot exclude the
influence of other factors next to our independent variables.

Secondly, we cannot generalize our findings, neither to our population nor to other cases within
our theoretical domain. The high heterogeneity of the domain renders the application of our
findings to other cases that lie outside our population impossible. Further, we chose to use
purposive sampling, which prevents us from safely generalizing any effect size from our
sample to the entire population. However, this was not intended, as we set out to find country-
specific combinations of influencing factors. As purposive sampling provided the highest data
accuracy, this methodological approach still seems appropriate in hindsight.

Thirdly, we were not able to obtain data for all currencies for the whole timeframe that we
intended to study. While most currencies data was available, even beyond our measurement
period, some countries data proved to be only available for around 20 years. While this does
not render our results invalid, it would be preferable to obtain a complete dataset for all
currencies sampled. More severely weighs the unavailability of enough data for Chile and Iran,
which forced us to exclude these two countries from our list. Particularly, in light of Chiles
and Irans strong dependency on their copper and oil exports these two countries would have
represented interesting cases. More generally, one can remark that a larger sample size could
have allowed us to draw more extensive theoretical implications.

Lastly, even though we found an apparent relationship between commodity prices and the
exchange rate changes of heavy exporters of these commodities, this relationship does not seem
to hold in every case. We expected to find significant results e.g. for the oil price and the value
of the RUB (Russian Ruble), however did not obtain such. This inconsistency between
countries emphasizes that the reader should not exclusively rely on our results and that further
research will need to be conducted to illuminate various factors that influence exchange rate
changes.

Following the previous drawbacks, we want to emphasize that our model is not to be considered
in isolation and does not mark the end of the search for a comprehensive model that can predict
exchange rate movements entirely. For this reason, the science community should focus on
finding additional influencing factors instead of testing for the basic UIP hypothesis. Building
upon our findings we suggest that future research should test in the opposite direction, namely
51
if and how exchange rate changes influence commodity prices. Alternatively, a similar test to
ours should be performed using high frequency data, regressing daily changes in exchange
rates on daily changes in commodity prices. Further, one could refine our model and make it
even more country-specific by selecting the main exported commodities of each country
individually instead of taking the 10 most-traded commodities worldwide. As seen in our
results, most currencies seem to be influenced more strongly by prices of commodities that the
respective country heavily trades in. Thus, by forming individual models for each country with
only a small selective number of commodities as independent variables, one could potentially
explain even more of the exchange rate puzzle for that specific country.

52
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55
 Appendix
Appendix A
Table 1: Results from past papers
Time Lower Bound Upper Bound
Study Country Horizon Beta SE CI CI
Chinn&Meredith(2004) Germany Monthly 0.924 0.232 0.469 1.379
Chinn&Meredith(2004) Japan Monthly 0.399 0.144 0.117 0.681
Chinn&Meredith(2004) UK Monthly 0.563 0.104 0.359 0.767
Chinn&Meredith(2004) France Monthly 0.837 0.442 -0.029 1.703
Chinn&Meredith(2004) Italy Monthly 0.197 0.151 -0.099 0.493
Chinn&Meredith(2004) Canada Monthly 1.120 0.355 0.424 1.816
Flood&Rose(2001) Argentina Monthly 0.000 0.010 -0.020 0.020
Flood&Rose(2001) Australia Monthly -3.580 2.550 -8.578 1.418
Flood&Rose(2001) Brazil Monthly 0.190 0.010 0.170 0.210
Flood&Rose(2001) Canada Monthly -0.580 0.540 -1.638 0.478
Flood&Rose(2001) Czech Rep Monthly -1.270 0.850 -2.936 0.396
Flood&Rose(2001) Denmark Monthly -0.030 0.700 -1.402 1.342
Flood&Rose(2001) Finland Monthly 7.060 3.800 -0.388 14.508
Flood&Rose(2001) France Monthly -1.420 0.620 -2.635 -0.205
Flood&Rose(2001) Germany Monthly 0.130 1.110 -2.046 2.306
Flood&Rose(2001) Hong Kong Monthly 0.000 0.030 -0.059 0.059
Flood&Rose(2001) Indonesia Monthly -1.190 1.130 -3.405 1.025
Flood&Rose(2001) Italy Monthly 0.290 2.550 -4.708 5.288
Flood&Rose(2001) Japan Monthly -1.710 1.110 -3.886 0.466
Flood&Rose(2001) Korea Monthly 0.000 0.000
Flood&Rose(2001) Malaysia Monthly 2.240 2.080 -1.837 6.317
Flood&Rose(2001) Mexico Monthly -0.770 0.700 -2.142 0.602
Flood&Rose(2001) Norway Monthly 0.590 0.750 -0.880 2.060
Flood&Rose(2001) Russia Monthly 0.220 0.110 0.004 0.436
Flood&Rose(2001) Sweden Monthly -0.440 0.950 -2.302 1.422
Flood&Rose(2001) Switzerland Monthly -2.080 1.400 -4.824 0.664
Flood&Rose(2001) Thailand Monthly -0.830 1.800 -4.358 2.698
Flood&Rose(2001) UK Monthly -1.260 0.970 -3.161 0.641
Flood&Rose(2001) Fixed ex. Monthly -0.930 -0.930 -0.930
Flood&Rose(2001) Floating ex. Monthly -0.200 -0.200 -0.200
Flood&Rose(2001) Pooled Monthly 0.190 0.190 0.190
Bansal&Dahlquist (2000) Switzerland Monthly 1.050 0.600 -0.126 2.226
Bansal&Dahlquist (2000) Hong Kong Monthly -0.010 0.160 -0.324 0.304
Bansal&Dahlquist (2000) Singapore Monthly -1.260 1.500 -4.200 1.680

56
Bansal&Dahlquist (2000) Japan Monthly -2.210 0.530 -3.249 -1.171
Bansal&Dahlquist (2000) Belgium Monthly -0.770 0.400 -1.554 0.014
Bansal&Dahlquist (2000) Austria Monthly -0.760 0.570 -1.877 0.357
Bansal&Dahlquist (2000) Denmark Monthly -0.560 0.340 -1.226 0.106
Bansal&Dahlquist (2000) Canada Monthly -1.040 0.330 -1.687 -0.393
Bansal&Dahlquist (2000) France Monthly 0.000 0.610 -1.196 1.196
Bansal&Dahlquist (2000) Germany Monthly -0.560 0.630 -1.795 0.675
Bansal&Dahlquist (2000) Netherlands Monthly -1.380 0.550 -2.458 -0.302
Bansal&Dahlquist (2000) Italy Monthly 0.080 0.320 -0.547 0.707
Bansal&Dahlquist (2000) UK Monthly -1.550 0.610 -2.746 -0.354
Bansal&Dahlquist (2000) Australia Monthly -8.400 3.110 -14.496 -2.304
Bansal&Dahlquist (2000) Sweden Monthly 0.560 0.570 -0.557 1.677
Bansal&Dahlquist (2000) Spain Monthly 0.670 0.420 -0.153 1.493
Bansal&Dahlquist (2000) Portugal Monthly 0.460 0.200 0.068 0.852
Bansal&Dahlquist (2000) Poland Monthly 0.460 0.500 -0.520 1.440
Bansal&Dahlquist (2000) Greece Monthly -0.380 0.180 -0.733 -0.027
Bansal&Dahlquist (2000) Czech Rep. Monthly 1.350 0.630 0.115 2.585
Bansal&Dahlquist (2000) Malaysia Monthly 0.350 0.580 -0.787 1.487
Bansal&Dahlquist (2000) Argentina Monthly 0.080 0.070 -0.057 0.217
Bansal&Dahlquist (2000) Venezuela Monthly 0.710 0.310 0.102 1.318
Bansal&Dahlquist (2000) Thailand Monthly 0.530 2.970 -5.291 6.351
Bansal&Dahlquist (2000) Mexico Monthly -1.400 0.860 -3.086 0.286
Bansal&Dahlquist (2000) Turkey Monthly 0.280 0.200 -0.112 0.672
Bansal&Dahlquist (2000) Philippines Monthly 0.810 1.990 -3.090 4.710
Bansal&Dahlquist (2000) India Monthly -0.980 1.170 -3.273 1.313
Bansal&Dahlquist (2000) ALL Monthly 0.260 0.140 -0.014 0.534
Bansal&Dahlquist (2000) Developed Monthly -0.320 0.290 -0.888 0.248
Bansal&Dahlquist (2000) Emerging Monthly 0.190 0.190 -0.182 0.562
Mehl&Capiello (2007) Canada Monthly 0.610 0.320 -0.017 1.237
Mehl&Capiello (2007) Germany Monthly 0.860 0.120 0.625 1.095
Mehl&Capiello (2007) Japan Monthly 0.220 0.170 -0.113 0.553
Mehl&Capiello (2007) UK Monthly 0.850 0.230 0.399 1.301
Mehl&Capiello (2007) Australia Monthly 0.530 0.130 0.275 0.785
Mehl&Capiello (2007) Sweden Monthly 0.290 0.360 -0.416 0.996
Mehl&Capiello (2007) Switzerland Monthly 0.400 0.090 0.224 0.576
Mehl&Capiello (2007) Malaysia Monthly 0.210 0.130 -0.045 0.465
Mehl&Capiello (2007) Thailand Monthly 0.730 0.190 0.358 1.102
Mehl&Capiello (2007) Taiwan Monthly 0.250 0.160 -0.064 0.564
Mehl&Capiello (2007) All curr. Monthly 0.500 0.030 0.441 0.559
Mehl&Capiello (2007) Developed Monthly 0.520 0.030 0.461 0.579

57
 Mehl&Capiello (2007) Emerging Monthly 0.240 0.030 0.181 0.299
Lothian&Wu (2011)
Short-Term Interest France - UK Annualy 0.97 0.860 -0.716 2.656
Lothian&Wu (2011)
Short-Term Interest US - UK Annualy 0.14 0.160 -0.174 0.454
Lothian&Wu (2011)
Long-Term Interest France - UK Annualy 0.73 0.430 -0.113 1.573
Lothian&Wu (2011)
Long-Term Interest US - UK Annualy 0.39 0.280 -0.159 0.939
Lothian&Wu (2011)
1800-1913 France - UK Annualy 0.35 0.260 -0.160 0.860
Lothian&Wu (2011)
1800-1913 US - UK Annualy 0.42 0.730 -1.011 1.851
Lothian&Wu (2011)
1914-1949 France - UK Annualy 10.05 3.630 2.935 17.165
Lothian&Wu (2011)
1914-1949 US - UK Annualy 1.36 2.670 -3.873 6.593
Lothian&Wu (2011)
1950-1999 France - UK Annualy 0.7 0.490 -0.260 1.660
Lothian&Wu (2011)
1950-1999 US - UK Annualy 0.32 0.640 -0.934 1.574
Chaboud&Wright(2004) Switzerland Overnight 0.79 0.690 -0.562 2.142
Chaboud&Wright(2004) Germany Overnight 1.02 0.730 -0.411 2.451
Chaboud&Wright(2004) UK Overnight 1.44 0.720 0.029 2.851
Chaboud&Wright(2004) Japan Overnight -1 0.840 -2.646 0.646
Table 1: Results from past papers

58
Appendix B
Monthly

Scatter Plot 1: Australia Scatter Plot 2: Brazil Scatter Plot 3: Canada

Scatter Plot 4: China Scatter Plot 5: EU19 Scatter Plot 6: Great Britain

Scatter Plot 7: India Scatter Plot 8: Japan Scatter Plot 9: Mexico

59
 Scatter Plot 10: Russia Scatter Plot 11: Saudi Arabia Scatter Plot 12: South Africa

Quarterly

Scatter Plot 13: Australia Scatter Plot 14: Brazil Scatter Plot 15: Canada

Scatter Plot 16: China Scatter Plot 17: EA19 Scatter Plot 18: Great Britain

60
 Scatter Plot 19: India Scatter Plot 20: Japan Scatter Plot 21: Mexico

Scatter Plot 22: Russia Scatter Plot 23: Saudi Arabia Scatter Plot 24: South Africa

61
Appendix C
Table 2: Uncovered Interest Parity Regression monthly data

Country Correlation Reg. Co. unstd. N-W SE (12 lags) Significance Adj. R
Australia -.003 -.056 1.309 .966 -.004
Brazil -.093 -.144 .177 .415 .003
Canada -.009 -.126 .514 .807 -.003
China .351 .647 .171 .000 .118
Euro Zone -.033 -.521 .784 .507 .001
Great Britain .032 .501 .972 .606 -.002
India .019 .024 .094 .800 -.004
Japan -.038 -.489 .628 .437 -.001
Mexico -.124 -.580 .260 .027 .011
Russia .413 1.203 .243 .000 .165
South Africa .144 .031 .014 .027 .017

Table 2: UIP Monthly Regression

Table 3: Uncovered Interest Parity Regression quarterly data

Country Correlation Reg. Co. unstd. N-W SE (6 lags) Significance Adj. R
Australia -.068 -1.095 2.158 .613 -.007
Brazil .118 .238 .196 .229 -.003
Canada .02 .212 .835 .800 -.009
China .487 .758 .216 .001 .224
Euro Zone -.013 -.133 .867 .878 -.008
Great Britain .016 .155 1.050 .883 -.009
India -.058 -.062 .162 .702 -.01
Japan -.088 -.982 .989 .323 -.001
Mexico -.126 -.435 .259 .097 .004
Russia .042 .130 .396 .744 -.018
South Africa .291 .106 .045 .019 .075
Table 3: UIP Quarterly Regression

62
 Table 4: General Economic Factor Regression quarterly data

Country Variable Reg. Co. unstd. N-W SE (6 lags) Significance Adj. R

Australia Interest rate diff. -.454 2.400 .0.836 .033

Current Acc. diff. -.038 .022 .123
Inflation diff. -.010 .008 .203
GDP Growth diff. .019 .014 .217
Brazil Interest rate diff. .270 .182 .137 -.012
Current Acc. diff. -.006 .005 .156
Inflation diff. -.006 .005 .241
GDP Growth diff. -.009 .011 .421
Canada Interest rate diff. .559 .883 .532 .002
Current Acc. diff. -.000 .000 .678
Inflation diff. -.007 .005 .123
GDP Growth diff. .004 .008 .634
China Interest rate diff. .747 .192 .000 .240
Current Acc. diff. .001 .002 .634
Inflation diff. -.001 .001 .064
GDP Growth diff. -.002 .002 .243
Euro Zone Interest rate diff. .892 2.439 .713 .088
Current Acc. diff. -.001 .001 .416
Inflation diff. -.027 .007 .000
GDP Growth diff. -.013 .012 .292
Great Britain Interest rate diff. .336 1.224 .755 .010
Current Acc. diff. .004 .001 .002
Inflation diff. -.004 .003 .172
GDP Growth diff. -.004 .007 .633
India Interest rate diff. -.032 .173 .853 .015
Current Acc. diff. -.002 .000 .000
Inflation diff. -4.078E-5 .001 .969
GDP Growth diff. -.005 .005 .330
Japan Interest rate diff. -.255 1.405 .862 -.038
Current Acc. diff. -.001 .006 .769
Inflation diff. .001 .004 .821
GDP Growth diff. -.006 .009 .532
Mexico Interest rate diff. -.858 .589 .148 -.026
Current Acc. diff. -.001 .002 .749
Inflation diff. .002 .001 .332
GDP Growth diff. -.003 .005 .599
Russia Interest rate diff. -.072 .608 .880 -.020
Current Acc. diff. -.016 .016 .422

63
 Inflation diff. .003 .004 .417
GDP Growth diff. .023 .014 .159
South Africa Interest rate diff. .099 .044 .027 .064
Current Acc. diff. .000 .001 .808
Inflation diff. -.003 .003 .334
GDP Growth diff. -.016 .011 .159

Table 4: General Economic Factors Regression

Table 5: Commodity Price Regression monthly data

Country Variable Reg. Co. unstd. N-W SE (12 lags) Significance Adj. R
Australia Interest rate diff. .039 1.010 .969 .296
Oil price change .054 .012 .047
Gas price change .017 .012 .155
Gold price change .009 .080 .913
Wheat price change .017 .022 .446
Cotton price change .024 .023 .303
Corn price change .026 .021 .237
Sugar price change .015 .015 .337
Silver price change .082 .029 .007
Copper price change .132 .037 .000
Brazil Interest rate diff. -.024 .138 .865 .203
Oil price change .044 .039 .260
Gas price change -.021 .018 .261
Gold price change -.248 .146 .043
Wheat price change .042 .029 .161
Cotton price change .044 .041 .282
Corn price change .029 .031 .361
Sugar price change .175 .042 .483
Silver price change .194 .061 .002
Copper price change .107 .040 .009
Canada Interest rate diff. -.092 .516 .865 .269
Oil price change -.086 .013 .011
Gas price change -.018 .003 .002
Gold price change .083 .040 .740
Wheat price change -.001 .010 .901
Cotton price change -.022 .015 .131
Corn price change -.012 .016 .449
Sugar price change .008 .009 .392
Silver price change -.056 .017 .002
Copper price change -.070 .016 .000

64
China Interest rate diff. .553 .205 .000 .156
Oil price change .014 .007 .040
Gas price change -.004 .003 .367
Gold price change .022 .014 .014
Wheat price change 9.180E-6 .003 .661
Cotton price change -.001 .003 .544
Corn price change .004 .003 .153
Sugar price change .002 .004 .714
Silver price change -.007 .007 .289
Copper price change -.007 .005 .186
Euro Zone Interest rate diff. -.871 .885 .034 .203
Oil price change .014 .016 .304
Gas price change .007 .010 .504
Gold price change .238 .040 .000
Wheat price change -.019 .016 .122
Cotton price change .040 .019 .045
Corn price change .025 .018 .211
Sugar price change -.007 .014 .648
Silver price change -.060 .029 .042
Copper price change .059 .017 .001
Great Britain Interest rate diff. .424 1.134 .710 .101
Oil price change .024 .021 .262
Gas price change .008 .007 .447
Gold price change .158 .034 .000
Wheat price change .001 .017 .960
Cotton price change .022 .019 .264
Corn price change .012 .021 .521
Sugar price change -.014 .019 .478
Silver price change -.051 .028 .072
Copper price change .078 .020 .000
India Interest rate diff. .099 .092 .269 .024
Oil price change .013 .011 .264
Gas price change -.003 .012 .791
Gold price change -.028 .032 .386
Wheat price change .022 .016 .176
Cotton price change .024 .022 .285
Corn price change .002 .015 .905
Sugar price change .011 .010 .324
Silver price change .036 .021 .087
Copper price change .004 .025 .869

65
 Japan Interest rate diff. -.444 .622 .476 .072
Oil price change .022 .020 .280
Gas price change -.010 .011 .382
Gold price change .260 .060 .000
Wheat price change -.009 .017 .621
Cotton price change .011 .023 .624
Corn price change -.006 .014 .686
Sugar price change .012 .016 .477
Silver price change -.061 .033 .069
Copper price change -.031 .034 .370
Mexico Interest rate diff. -.497 .225 .028 .184
Oil price change .045 .195 .023
Gas price change .004 .008 .687
Gold price change -.173 .079 .030
Wheat price change .013 .015 .405
Cotton price change .008 .026 .768
Corn price change .013 .017 .440
Sugar price change .027 .026 .309
Silver price change .046 .018 .073
Copper price change .103 .037 .000
Russia Interest rate diff. 1.201 .199 .000 .333
Oil price change .160 .056 .005
Gas price change -.021 .016 .200
Gold price change .035 .057 .551
Wheat price change -.030 .028 .297
Cotton price change .030 .028 .290
Corn price change -.004 .029 .886
Sugar price change -.001 .019 .967
Silver price change -.011 .037 .774
Copper price change .048 .032 .148
South Africa Interest rate diff. .034 .013 .012 .042
Oil price change .067 .034 .049
Gas price change -.009 .019 .625
Gold price change -.070 .066 .293
Wheat price change .026 .012 .234
Cotton price change .008 .037 .829
Corn price change -.005 .028 .874
Sugar price change .015 .027 .578
Silver price change .023 .040 .581
Copper price change .049 .052 .355

Table 5: Commodity Prices Regression

66
Appendix D
Table 6: Robustness Test Regression monthly data

USD GBP

Reg. Co. N-W SE (12 Significance Reg. Co. N-W SE (12 Significance
unstd lags) unstd lags)
Country Variable
Australia Oil-Price .034 .018 .066 .112 .018 .000
Gas-Price .087 .012 .015 -.009 .011 .447
Gold-Price .012 .080 .877 .151 .077 .034
Wheat-Price .017 .022 .444 -.016 .023 .505
Cotton-Price .024 .023 .300 -.008 .021 .697
Corn-Price .036 .021 .233 -.020 .012 .466
Sugar-Price .015 .016 .341 -.029 .019 .152
Silver-Price .080 .029 .007 -.120 .031 .000
Copper-Price .132 .037 .000 -.048 .029 .105
Brazil Oil-Price .065 .040 .113 .106 .066 .003
Gas-Price -.015 .018 .397 .032 .027 .245
Gold-Price -.242 .117 .343 .136 .151 .371
Wheat-Price .044 .030 .147 -.078 .042 .069
Cotton-Price .040 .029 .178 .037 .057 .519
Corn-Price .015 .027 .560 -.013 .053 .810
Sugar-Price .174 .045 .108 .169 .065 .451
Silver-Price .191 .065 .166 .089 .087 .655
Copper-Price .128 .029 .001 .129 .082 .039
Canada Oil-Price -.035 .013 .011 .108 .017 .000
Gas-Price -.018 .005 .002 .013 .011 .240
Gold-Price .012 .039 .479 .171 .045 .000
Wheat-Price -.001 .010 .903 -.002 .018 .900
Cotton-Price -.023 .014 .129 -.001 .019 .969
Corn-Price -.012 .015 .447 -.003 .025 .916
Sugar-Price .008 .009 .403 -.001 .021 .960
Silver-Price .055 .017 .002 -.104 .029 .001
Copper-Price -.070 .017 .000 .005 .018 .783
China Oil-Price .008 .004 .074 .004 .028 .867
Gas-Price -.002 .002 .275 .005 .010 .617
Gold-Price .018 .009 .051 .159 .036 .000
Wheat-Price -.003 .003 .431 .022 .017 .186
Cotton-Price -.001 .003 .759 .013 .016 .431
Corn-Price .008 .004 .071 .004 .021 .869

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 Sugar-Price .002 .002 .450 -.016 .018 .396
Silver-Price -.005 .004 .320 -.011 .025 .648
Copper-Price -.001 .003 .830 .082 .027 .004
Euro Zone Oil-Price .013 .016 .424 .029 .041 .479
Gas-Price .007 .010 .502 .009 .013 .516
Gold-Price .239 .039 .000 .142 .068 .004
Wheat-Price -.018 .015 .235 .001 .022 .947
Cotton-Price .040 .019 .046 .012 .029 .695
Corn-Price .025 .020 .223 .004 .024 .857
Sugar-Price -.006 .014 .659 -.010 .014 .466
Silver-Price -.060 .028 .040 -.050 .054 .359
Copper-Price .058 .018 .002 .049 .029 .102
India Oil-Price .037 .009 .448 -.012 .025 .632
Gas-Price -.001 .011 .928 .009 .013 .494
Gold-Price -.009 .029 .756 -.140 .055 .030
Wheat-Price .032 .018 .088 -.009 .019 .650
Cotton-Price .034 .020 .101 .000 .017 .993
Corn-Price -.012 .014 .420 -.004 .022 .866
Sugar-Price -.013 .021 .546 -.009 .021 .689
Silver-Price .029 .017 .097 -.033 .030 .271
Copper-Price .011 .018 .577 .032 .012 .261
Japan Oil-Price .021 .020 .298 .004 .033 .914
Gas-Price -.010 .011 .398 .014 .014 .330
Gold-Price .260 .060 .000 .204 .063 .000
Wheat-Price -.009 .017 .620 .013 .024 .613
Cotton-Price .012 .023 .619 .006 .027 .821
Corn-Price -.005 .014 .703 .007 .028 .794
Sugar-Price .012 .016 .483 -.022 .021 .306
Silver-Price -.061 .033 .067 -.079 .032 .772
Copper-Price -.030 .033 .370 .110 .045 .010
Mexico Oil-Price .047 .017 .008 -.030 .028 .294
Gas-Price .021 .023 .387 -.024 .029 .400
Gold-Price -.185 .078 .018 .341 .087 .000
Wheat-Price .033 .026 .213 -.033 .030 .280
Cotton-Price -.032 .042 .455 .048 .041 .254
Corn-Price -.004 .012 .861 .012 .032 .699
Sugar-Price .005 .031 .867 .000 .036 .989
Silver-Price .070 .029 .020 -.101 .037 .008
Copper-Price .105 .037 .018 .162 .031 .607
Russia Oil-Price .219 .046 .677 .348 .067 .000

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 Gas-Price -.024 .022 .288 .012 .022 .590
Gold-Price -.119 .119 .322 .301 .165 .051
Wheat-Price -.042 .043 .325 .078 .039 .047
Cotton-Price .012 .044 .787 -.013 .033 .694
Corn-Price .091 .053 .080 -.038 .049 .440
Sugar-Price .081 .082 .325 -.129 .114 .259
Silver-Price .046 .069 .511 -.138 .105 .193
Copper-Price .131 .063 .040 .017 .040 .682
South Oil-Price .067 .035 .058 -.017 .023 .470
Africa Gas-Price -.010 .019 .608 .000 .008 .976
Gold-Price -.073 .066 .273 .095 .0115 .011
Wheat-Price .026 .021 .235 .015 .059 .543
Cotton-Price .013 .038 .742 .000 .024 .999
Corn-Price -.011 .028 .696 .011 .031 .674
Sugar-Price .017 .026 .529 -.014 .026 .731
Silver-Price .023 .039 .561 -.147 .030 .000
Copper-Price .043 .053 .425 -.002 .037 .903
Table 6: Robustness test regression monthly data

69