A Non-linear Analysis of Excess Foreign Exchange Returns.

In this paper we explore the dynamics of US dollar excess foreign exchange returns for the G10 currencies and the Swiss franc, 1976-97. The non-linear framework adopted is justified by the results of linearity tests and a parametric bootstrap likelihood ratio statistic which indicate threshold effects or differential adjustment to small and large excess returns. Impulse response analysis suggests that the effect of small shocks to excess returns inside the no-arbitrage band exhibits most persistence. Large shocks outside the band decay most rapidly and also exhibit overshooting. These phenomena are explained in terms of noise trading strategies and transaction costs. Copyright 2001 by Blackwell Publishers Ltd and The Victoria University of Manchester