Determinants of exchange rates and foreign exchange volatility
Date
2010-07
Authors
Karanja, Waiguru
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Abstract
Explaining the movements in the exchange rate is still a puzzle to economists particularly since the break down of the Bretton Wood system in the early 1970's, when many countries introduced a floating system. This paper tries to deepen our understanding of this puzzle by using a model that makes use of data from Singapore, the UK and Kenya.
The period covered is January 1993 and December 2008. The variables in the model
money supply, current account balance, capital account balance, official reserves balance,interest rate and inflation differential. The dependent variable is exchange rate. The model has purchasing power parity and uncovered interest parity as underlying
theoretical assumptions, two main building blocks of open macro economics.
A linear regression model was used to analyze the data. In addition Cointergration and
Granger-Simms causality tests were used to gain further insights into the research
problem.
The results show that most of the variables have an inverse relationship with the
exchange rate. In emerging and developing countries (Singapore and Kenya) it is the
exchange rate which influence the movement of economic fundamentals in question and not the other way round, although interest rate differential constitutes a significant
explanatory variable for exchange rate movements in all the three countries included in
the model. Both Singapore and the UK have also, in accordance with the RID model, the
expected negative sign on the coefficient. The results regarding the other variables are
mixed among the countries.
Description
A thesis submitted to Strathmore University in partial fulfillment of the requirements for the award of Master of Commerce Degree.
Keywords
Foreign Exchange Rates, Volatility