New Evidence on Interest Rate and Foreign Exchange Rate Modeling

This dissertation empirically and theoretically investigates threeinterrelated issues of market anomalies in interest rates derivativesand foreign exchange rates. The first essay models the spotexchange rate as a decomposition of permanent and transitorycomponents. Unlike extant analysis, the transitory componentcould be stationary or explosive. The second essay examines themarket efficiency hypothesis in the foreign exchange markets andrelates the rejection of forward rate unbiasedness hypothesis tothe existence of risk premium not to the failure of rationalexpectation. The third essay examines the behavior of short-termriskless rate and models the risk free rate as a nonlinear trendstationary process. While addressing these issues, these essaysaccount for: (1) finite sample bias; (2) Unit root and othernonstationary behaviors; (3) the role of nonlinear trend; and (4)the interrelations between different behaviors. Several new resultshave been gleaned from our analysis; we find that: (1) the spotexchange rates display a very slow mean aversion behavior,which implies the failure of the purchasing power parity; (2) thereare positive autocorrelations across the long horizons overlappingreturns increases overtime and then begin to decline at a very longhorizon period; (3) the short-term riskless rate displays anonlinear trend stationary process which is closer to driftlessrandom walk behavior; (4) modifying the mean reverting shortterminterest rates models to a nonlinear trend stationary shows anextreme improvement and outperforms all suggested models; (5)the traditional tests for rational expectations and market efficiencyin the foreign exchange markets are subject to size distortions; (6)we relate the rejection of market efficiency in the foreignexchange markets documented across most currencies to theexistence of risk premium not to the rejection of rationalexpectation hypothesis.