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Book part
Publication date: 24 March 2006

Dennis W. Jansen and Zijun Wang

The “Fed Model” postulates a cointegrating relationship between the equity yield on the S&P 500 and the bond yield. We evaluate the Fed Model as a vector error correction

Abstract

The “Fed Model” postulates a cointegrating relationship between the equity yield on the S&P 500 and the bond yield. We evaluate the Fed Model as a vector error correction forecasting model for stock prices and for bond yields. We compare out-of-sample forecasts of each of these two variables from a univariate model and various versions of the Fed Model including both linear and nonlinear vector error correction models. We find that for stock prices the Fed Model improves on the univariate model for longer-horizon forecasts, and the nonlinear vector error correction model performs even better than its linear version.

Details

Econometric Analysis of Financial and Economic Time Series
Type: Book
ISBN: 978-1-84950-388-4

Book part
Publication date: 1 January 2005

T.J. Brailsford, J.H.W. Penm and R.D. Terrell

Vector error-correction models (VECMs) have become increasingly important in their application to financial markets. Standard full-order VECM models assume non-zero entries in all…

Abstract

Vector error-correction models (VECMs) have become increasingly important in their application to financial markets. Standard full-order VECM models assume non-zero entries in all their coefficient matrices. However, applications of VECM models to financial market data have revealed that zero entries are often a necessary part of efficient modelling. In such cases, the use of full-order VECM models may lead to incorrect inferences. Specifically, if indirect causality or Granger non-causality exists among the variables, the use of over-parameterised full-order VECM models may weaken the power of statistical inference. In this paper, it is argued that the zero–non-zero (ZNZ) patterned VECM is a more straightforward and effective means of testing for both indirect causality and Granger non-causality. For a ZNZ patterned VECM framework for time series of integrated order two, we provide a new algorithm to select cointegrating and loading vectors that can contain zero entries. Two case studies are used to demonstrate the usefulness of the algorithm in tests of purchasing power parity and a three-variable system involving the stock market.

Details

Research in Finance
Type: Book
ISBN: 978-0-76231-277-1

Book part
Publication date: 24 April 2023

Nikolay Gospodinov, Alex Maynard and Elena Pesavento

It is widely documented that while contemporaneous spot and forward financial prices trace each other extremely closely, their difference is often highly persistent and the…

Abstract

It is widely documented that while contemporaneous spot and forward financial prices trace each other extremely closely, their difference is often highly persistent and the conventional cointegration tests may suggest lack of cointegration. This chapter studies the possibility of having cointegrated errors that are characterized simultaneously by high persistence (near-unit root behavior) and very small (near zero) variance. The proposed dual parameterization induces the cointegration error process to be stochastically bounded which prevents the variables in the cointegrating system from drifting apart over a reasonably long horizon. More specifically, this chapter develops the appropriate asymptotic theory (rate of convergence and asymptotic distribution) for the estimators in unconditional and conditional vector error correction models (VECM) when the error correction term is parameterized as a dampened near-unit root process (local-to-unity process with local-to-zero variance). The important differences in the limiting behavior of the estimators and their implications for empirical analysis are discussed. Simulation results and an empirical analysis of the forward premium regressions are also provided.

Book part
Publication date: 26 April 2014

Panayiotis F. Diamandis, Anastassios A. Drakos and Georgios P. Kouretas

The purpose of this paper is to provide an extensive review of the monetary model of exchange rate determination which is the main theoretical framework on analyzing exchange rate…

Abstract

Purpose

The purpose of this paper is to provide an extensive review of the monetary model of exchange rate determination which is the main theoretical framework on analyzing exchange rate behavior over the last 40 years. Furthermore, we test the flexible price monetarist variant and the sticky price Keynesian variant of the monetary model. We conduct our analysis employing a sample of 14 advanced economies using annual data spanning the period 1880–2012.

Design/methodology/approach

The theoretical background of the paper relies on the monetary model to the exchange rate determination. We provide a thorough econometric analysis using a battery of unit root and cointegration testing techniques. We test the price-flexible monetarist version and the sticky-price version of the model using annual data from 1880 to 2012 for a group of industrialized countries.

Findings

We provide strong evidence of the existence of a nonlinear relationship between exchange rates and fundamentals. Therefore, we model the time-varying nature of this relationship by allowing for Markov regime switches for the exchange rate regimes. Modeling exchange rates within this context can be motivated by the fact that the change in regime should be considered as a random event and not predictable. These results show that linearity is rejected in favor of an MS-VECM specification which forms statistically an adequate representation of the data. Two regimes are implied by the model; the one of the estimated regimes describes the monetary model whereas the other matches in most cases the constant coefficient model with wrong signs. Furthermore it is shown that depending on the nominal exchange rate regime in operation, the adjustment to the long run implied by the monetary model of the exchange rate determination came either from the exchange rate or from the monetary fundamentals. Moreover, based on a Regime Classification Measure, we showed that our chosen Markov-switching specification performed well in distinguishing between the two regimes for all cases. Finally, it is shown that fundamentals are not only significant within each regime but are also significant for the switches between the two regimes.

Practical implications

The results are of interest to practitioners and policy makers since understanding the evolution and determination of exchange rates is of crucial importance. Furthermore, our results are linked to forecasting performance of exchange rate models.

Originality/value

The present analysis extends previous analyses on exchange rate determination and it provides further support in favor of the monetary model as a long-run framework to understand the evolution of exchange rates.

Details

Macroeconomic Analysis and International Finance
Type: Book
ISBN: 978-1-78350-756-6

Keywords

Article
Publication date: 28 March 2018

Qi Deng

The existing literature on the Black-Litterman (BL) model does not offer adequate guidance on how to generate investors’ views in an objective manner. Therefore, the purpose of…

Abstract

Purpose

The existing literature on the Black-Litterman (BL) model does not offer adequate guidance on how to generate investors’ views in an objective manner. Therefore, the purpose of this paper is to establish a generalized multivariate Vector Error Correction Model (VECM)/Vector Auto-Regressive (VAR)-Dynamic Conditional Correlation (DCC)/Asymmetric DCC (ADCC) framework, and applies it to generate objective views to improve the practicality of the BL model.

Design/methodology/approach

This paper establishes a generalized VECM/VAR-DCC/ADCC framework that can be utilized to model multivariate financial time series in general, and produce objective views as inputs to the BL model in particular. To test the VECM/VAR-DCC/ADCC preconditioned BL model’s practical utility, it is applied to a six-asset China portfolio (including one risk-free asset).

Findings

With dynamically optimized view confidence parameters, the VECM/VAR-DCC/ADCC preconditioned BL model offers clear advantage over the standard mean-variance method, and provides an automated portfolio optimization alternative to the classic BL approach.

Originality/value

The VECM/VAR-DCC/ADCC framework and its application in the BL model proposed by this paper provide an alternative approach to the classic BL method. Since all the view parameters, including estimated mean return vectors, conditional covariance matrices and pick matrices, are generated in the VECM/VAR and DCC/ADCC preconditioning stage, the model improves the objectiveness of the inputs to the BL stage. In conclusion, the proposed model offers a practical choice for automated portfolio balancing and optimization in a China context.

Details

China Finance Review International, vol. 8 no. 4
Type: Research Article
ISSN: 2044-1398

Keywords

Article
Publication date: 1 January 1998

Ali F. Darrat, M. Zhong, R.M. Shelor and R.N. Dickens

This study uses the Vector Error Correction Model (VECM) to forecast ex post changes in earning and stock prices of six major DOW companies as well as of the S&P 500 market index…

Abstract

This study uses the Vector Error Correction Model (VECM) to forecast ex post changes in earning and stock prices of six major DOW companies as well as of the S&P 500 market index. Compared to ARIMA and GARCH models, results from four decades of data are supportive of the forecasting ability of the VECM process.

Details

Studies in Economics and Finance, vol. 19 no. 1/2
Type: Research Article
ISSN: 1086-7376

Article
Publication date: 29 July 2014

Kim Hin David Ho, Satyanarain Rengarajan and John Glascock

The purpose of this paper is to examine the structure and dynamics of Singapore's Central Area office market. A long-run equilibrium relationship is tested and a short-run…

Abstract

Purpose

The purpose of this paper is to examine the structure and dynamics of Singapore's Central Area office market. A long-run equilibrium relationship is tested and a short-run adjustment error correction model are estimated, incorporating appropriate serial error correction. The long-run equation is estimated for office rent, with office employment and available stock.

Design/methodology/approach

With the vector error correction model (VECM), the lagged rent, available stock, office employment, vacancy and occupied stock (OS) can impact the rental adjustment process. Equilibrium rent on the whole reacts positively to lagged rents, available stock, office employment, OS and negatively to vacancy rates (VC). Past levels of positive change in VC and rental growth can have negative effects on current OS.

Findings

While good economic conditions signaled by increases in rents increase the supply of new stock (available space), higher rents and VC dampen the long-term occupied space (space absorption) in accordance with economic theory. Available stock can be forecasted by past rent and absorption levels owing to the developer's profit-driven nature.

Research limitations/implications

An understanding of the interaction between the macroeconomic variables and the Central Area office market is useful to domestic and foreign investors and developers, who then can better evaluate their decision making in commercial real estate investment and development projects.

Practical implications

It is implicit that the Singapore Central Area office market requires at least a year before any rental increase can potentially dampen the space demanded. Firms are attracted to locate there owing to agglomeration economies and they are willing to pay premium office rents in conjunction with office space intensification in the Central Area. Newly built space is positively affected by past rents. Urban Redevelopment Authority and private real estate developers should be wary of excess office sector vacancies by avoiding over supply, even though an increase in the supply of office space in the Central Area can have a positive impact on office rent in the longer term. Most of the office space development would tend to meet the demand in the long run. Rental stickiness is exemplified as rental changes are affected by lagged rent.

Social implications

Policy makers are better enabled to stabilize the office sectors of the real estate market if so required.

Originality/value

The paper adopts the VECM and validated by empirical evidence, to investigate the long-run equilibrium relationship and short-term corrections underlying the dynamics of the Singapore Central office market. Delay in the restoration of equilibrium in real estate markets is attributed to factors like lease terms and supply lags.

Details

Journal of Property Investment & Finance, vol. 32 no. 5
Type: Research Article
ISSN: 1463-578X

Keywords

Abstract

Details

New Directions in Macromodelling
Type: Book
ISBN: 978-1-84950-830-8

Book part
Publication date: 24 March 2005

T.J. Brailsford, J.H.W. Penm and R.D. Terrell

Conventional methods to test for long-term PPP based on the theory of cointegration are typically undertaken in the framework of vector error correction models (VECM). The…

Abstract

Conventional methods to test for long-term PPP based on the theory of cointegration are typically undertaken in the framework of vector error correction models (VECM). The standard approach in the use of VECMs is to employ a model of full-order, which assumes nonzero entries in all the coefficient matrices. But, the use of full-order VECM models may lead to incorrect inferences if zero entries are required in the coefficient matrices. Specifically, if we wish to test for indirect causality, instantaneous causality, or Granger non-causality, and employ “overparameterised” full-order VECM models that ignore entries assigned a priori to be zero, then the power of statistical inference is weakened and the resultant specifications can produce different conclusions concerning the cointegrating relationships among the variables. In this paper, an approach is presented that incorporates zero entries in the VECM analysis. This approach is a more straightforward and effective means of testing for causality and cointegrating relations. The paper extends prior work on PPP through an investigation of causality between the U.S. Dollar and the Japanese Yen. The results demonstrate the inconsistencies that can arise in the area and show that bi-directional feedback exists between prices, interest rates and the exchange rate such that adjustment mechanisms are complete within the context of PPP.

Details

Research in Finance
Type: Book
ISBN: 978-0-76231-161-3

Article
Publication date: 26 July 2011

Palamalai Srinivasan, M. Kalaivani and P. Ibrahim

This paper aims to investigate the causal nexus between foreign direct investment (FDI) and economic growth in SAARC countries.

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Abstract

Purpose

This paper aims to investigate the causal nexus between foreign direct investment (FDI) and economic growth in SAARC countries.

Design/methodology/approach

Johansen's cointegration test was employed to examine the long‐run relationship between foreign direct investment and economic growth in SAARC countries. Besides, the vector error correction model (VECM) was employed to examine the causal nexus between foreign direct investment and economic growth in SAARC countries for the years 1970‐2007. Finally, the impulse response function (IRF) has been employed to investigate the time paths of log of foreign direct investment (LFDI) in response to one‐unit shock to the log of gross domestic product (LGDP) and vice versa.

Findings

The Johansen cointegration result establishes a long‐run relationship between foreign direct investment and gross domestic product (GDP) for the sample of SAARC nations, namely, Bangladesh, India, Maldives, Nepal, Pakistan and Sri Lanka. The empirical results of the vector error correction model exhibit a long‐run bidirectional causal link between GDP and FDI for the selected SAARC nations except India. The test results show that there is a one‐way long‐run causal link from GDP to FDI for India.

Research limitations/implications

This paper employed annual data to examine the causal nexus between FDI and economic growth. Therefore, researchers are encouraged to test the FDI‐growth relationship further by using quarterly data.

Practical implications

The SAARC nations should adopt effective policy measures that would substantially enlarge and diversify their economic base, improve local skills and build up a stock of human capital recourses capabilities, enhance economic stability and liberalise their market in order to attract as well as benefit from long‐term FDI inflows.

Originality/value

This paper would be immensely helpful to the policy makers of SAARC countries to plan their FDI policies in a way that would enhance growth and development of their respective economies.

Details

Journal of Asia Business Studies, vol. 5 no. 2
Type: Research Article
ISSN: 1558-7894

Keywords

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