Trading Intensity

INEC-02750; No of Pages 16
Journal of International Economics xxx (2014) xxxxxx
Contents lists available at ScienceDirect
Journal of International Economics

journal homepage: www.elsevier.com/locate/jie
Trade intensity and purchasing power parity

Dooyeon Cho a,1, Antonio Doblas-Madrid b,
a
b
Department of Economics, Kookmin University, Seoul 136-702, Republic of Korea

Department of Economics, Michigan State University, 110 Marshall-Adams Hall, East Lansing, MI 48824, USA
a r t i c l e
i n f o
Article history:
Received 19 April 2011
Received in revised form 17 December 2013
Accepted 15 January 2014
Available online xxxx
JEL classication:
C13
C52
F31
F47
a b s t r a c t
In this paper, we seek to contribute to the PPP literature by presenting evidence of a link between trade intensity
and exchange rate dynamics. We rst establish a negative effect of trade intensity on exchange rate volatility
using panel regressions, with distance as an instrument to correct for endogeneity. We also estimate a nonlinear
model of mean reversion to compute half-lives of deviations of bilateral exchange rates from the levels dictated
by relative PPP, and nd these half-lives to be signicantly shorter for high trade intensity currency pairs. This
result does not appear to be driven by Central Bank intervention. Finally, we show that conditioning on PPP
may help improve the performance of popular currency trading strategies, such as the carry trade, especially
for low trade intensity currency pairs.
2014 Elsevier B.V. All rights reserved.
Keywords:
Trade intensity
Deviations from PPP
Exchange rate volatility
Carry trades
Mean reversion
1. Introduction
For international economists, exchange rate determination is a topic
of perennial interest and a formidable challenge. While some models
such as Taylor et al. (2001), Molodtsova and Papell (2009), Mark
(1995) and othershave outperformed Meese and Rogoff's (1983)
famous random walk, the fraction of movement explained, let alone
predicted, remains small.
According to Rogoff (2008), the most consistent empirical regularity
is purchasing power parity (PPP). Despite their volatility, real exchange
rates appear to revert back to long-run averages as predicted by relative
PPP. In this paper, we investigate whether the degree of trade intensity
(TI henceforth) between two countries affects mean reversion in their bilateral real exchange rate. Our hypothesis is straightforward. PPP is based
on the Law of One Price, which in turn relies on goods arbitrage. As deviations from PPP widen, the number of goods for which price differences
exceed transaction costs should increase. As agents exploit emerging opportunities for goods arbitrage, they increase demand for goods in cheap
locations and supply in expensive ones. This reequilibration should be
stronger between close trading partners, presumably due to lower transaction costswhich include transport and tariffs, but also xed costs like
translating, advertising, licensing, etc. Sooner or later, goods trade should
Corresponding author. Tel.: +1 517 355 8320; fax: +1 517 432 1068.
E-mail addresses: dcho@kookmin.ac.kr (D. Cho), doblasma@msu.edu (A. Doblas-Madrid).
1
Tel.: +82 2 910 5617; fax: +82 2 910 4519.
translate into currency trades and affect nominal exchange rates, which
typically drive most of the variability in real exchange rates. Although
turnover in foreign exchange (forex) markets far exceeds export values,
this stabilizing effect of exports on exchange rates need not be insignicant. In fact, forex market participants often claim that exports matter
because, while speculative traders drive most volume, they open and
close positions very frequently. By contrast, export driven transactions
generate positions that are opened but never closed, exerting pressure
on exchange rates in a much more consistent direction. Moreover, if
investors take trade into accountfor example by favoring countries
with trade surpluseswhen deciding which currencies to buy, speculative trades may actually complement the effect of exports.
We consider a sample of 91 currency pairs involving 14 countries
over the period 19802005. To dene and quantify TI, we largely follow
Betts and Kehoe (2008). Our measures of TI between countries A and B
are based on the magnitude of the bilateral trade between them, relative
to A's (and/or B's) total trade. Not surprisingly, TI and exchange rate
volatility are negatively correlated in our sample. This correlation is
likely a product of causality in both directions. As mentioned above, TI
may reduce volatility through goods arbitrage, which exerts pressure
to reduce deviations from PPP. In the other direction, there is the
argumentoften brought up in defense of xed exchange ratesthat
lower exchange rate volatility may increase trade between countries
by reducing uncertainty and hedging costs. Since we are primarily interested in the rst direction of causality, we begin the analysis by
implementing panel regressions with exchange rate volatility as a
0022-1996/$ see front matter 2014 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.jinteco.2014.01.007
Please cite this article as: Cho, D., Doblas-Madrid, A., Trade intensity and purchasing power parity, J. Int. Econ. (2014), http://dx.doi.org/10.1016/
j.jinteco.2014.01.007
D. Cho, A. Doblas-Madrid / Journal of International Economics xxx (2014) xxxxxx
dependent variable and TI as one of our independent variables, using

the distance between two countries as an instrument. This approach is
similar to that of Broda and Romalis (2009). Coefcient estimates
from these regressions across various specications show a negative
effect of TI between two countries on their bilateral real exchange
rate. We also nd that, consistent with the literature on carry trades
(see, for instance, Bhansali (2007)) exchange rate volatility increases
with the absolute value of interest rate differentials. While most of the
currencies in our sample are oating during all or most of the sample
period, there are some exceptions. However, our results remain qualitatively unchanged when we drop or control for pegged currency pairs.
Our results are moreover robust to the use of different measures of
exchange rate volatility and TI, and to considering only major currency
pairs, as opposed to minor/exotic pairs. Finally, the results are qualitatively preserved when we restrict attention to just the rst, or second
half, of the 19802005 period.
Motivated by Michael et al. (1997) and Taylor et al. (2001), who
provide evidence of nonlinear mean reversion in a number of major real
exchange rates, we quantify the size and persistence of PPP deviations
using a nonlinear model. Specically, we estimate an exponential smooth
transition autoregressive (ESTAR) model, which allows the speed at
which exchange rates converge to their long-run equilibrium values to
depend on the size of the deviations. The model allows for the possibility
that real exchange rates may behave like unit root processes when close
to their long-run equilibrium levels, while becoming increasingly meanreverting as they move away from equilibrium. For our comparison, we
restrict attention to 35 highest and 35 lowest currency pairs, as ordered
by TI. We make this choice to ensure that the difference in trade intensities between the two sets of currency pairs is so large and stable that variations of TI over time are negligible in comparison to the differences in
trade intensities between the two sets of pairs. After estimating the
ESTAR models, we investigate the dynamic adjustment in response to
shocks to real exchange rates in the estimated ESTAR model by computing the generalized impulse response functions (GIs) using the Monte
Carlo integration method introduced by Gallant et al. (1993). We nd
that, as hypothesized, the estimates of the half-lives of deviations from
PPP for a given currency pair are higher the less intense the trade relationship between two countries. For currency pairs in the high TI group, the
average half-life of deviations from PPP is given by 20.20 months, whereas for low TI pairs, it is 26.34 months. Moreover, this nding is statistically
signicant.
We also verify that our result is not driven by Central Bank intervention. That is, a possible concern when interpreting our results is that, if
Central Banks exhibit more fear of oating in response to exchange
rate uctuations against important trading partners, the observed
differences in volatility may primarily be due to ofcial reserve transactions, rather than trade. To address this concern, we consider various
proxies for interventionspecically the volatility of reserves and interest rates, following Calvo and Reinhart (2002). To judge by these
measures, government intervention is unlikely to be the reason for
faster convergence in high TI cases, since the degree of currency intervention is typically lower for high TI currency pairs.
Finally, we investigate whether our ndings on TI and mean reversion
can be used to improve the performance of forex trading strategies, such
as the carry trade. To do this, we perform an exercise similar to Jord and
Taylor (2012). We simulate a PPP-augmented carry trade, which gives a
buy signal only if there is a positive interest rate differential and the
high interest currency is undervalued according to relative PPP. The criterion to decide whether a currency is over- or undervalued is simply
whether the (lagged) real exchange rate is above or below its historical
average by a percentage . (The higher , the greater of degree of undervaluation needed to satisfy the PPP condition.) We compare the performance of this PPP-augmented carry trade to a plain carry trade, which
chases high interest rate differentials regardless of PPP valuations. We
do this separately for a high TI and for a low TI portfolio. Across all our
specications of the carry trade, the PPP-augmented strategy outperforms
the plain carry, in the sense that it has higher Sharpe ratios. These gains
from conditioning on PPP tend to be greater in the low TI portfolio. Moreover, the optimal is also higher in the low TI case. While these results are
obtained in sample, we nd that the same patterns do hold out-ofsample, although the gains from conditioning on PPP become smaller,
especially in the high TI group.
The rest of the paper is organized as follows. In Section 2, we describe
our data and dene variables. In Section 3, we provide evidence of a linkage between TI and exchange rate volatility using panel regressions. In
Section 4, we present and discuss empirical results from ESTAR models.
We also conduct and discuss stationary tests for estimated ESTAR
models. Further, we investigate whether our half-life estimates are mainly driven by government intervention. In Section 5, we apply our ndings
to currency trading strategies. In Section 6, we conclude.
2. Data and variable denitions
2.1. Data sources
We collect monthly nominal exchange rates vis--vis the US Dollar
(USD) from January 1980 through December 2008 for the following
13 currencies: Australian Dollar (AUD), Canadian Dollar (CAD),
Euro/Deutsche Mark (EUR/DEM), Great Britain Pound (GBP), Japanese
Yen (JPY), Korean Won (KRW), Mexican Peso (MXN), New Zealand
Dollar (NZD), Norwegian Krone (NOK), Singapore Dollar (SGD),
Swedish Krona (SEK), Swiss Franc (CHF), and Turkish Lira (TRY). To
choose the currencies, we follow the BIS Triennial Central Bank Survey,
and focus on the 20 most traded currencies in 2010. Six of the top
twenty currencies, the Hong Kong Dollar (in 8th place), Indian Rupee,
Russian Ruble, Chinese Renminbi, Polish Zloty (in places 1518), and
the South African Rand (in place number 20) were dropped due to
data limitations, being xed for most of the sample period, or both.
Combining each of the 14 currencies with the rest, we obtain a total of
91 bilateral trade relationships and real exchange rates.
For all 14 currencies, we collect monthly money market interest
rates, price indices, in particular the consumer price index (CPI), and
foreign exchange reserves. We retrieve these data from the IMF's
International Financial Statistics (IFS) database. Data for annual exports
used to measure trade intensity (TI) are borrowed from Betts and
Kehoe (2008).2
2.2. Measuring exchange rate volatility and trade intensity
The aim of this paper is to investigate the link between TI and exchange rate volatility. Our hypothesis is that the more intense the
trade relationship between two countries, the less volatile their bilateral
real exchange rate. To investigate the link between them, we start by
dening our measures of exchange rate volatility and TI.
The real exchange rate Qt is dened as
Q t St
Pt
;
P t
where St is the nominal exchange rate measured as the price of one unit
of domestic currency in terms of foreign currency, and Pt and Pt denote
domestic and foreign price levels, respectively. The log real exchange
rate qt is given by
qt st pt pt ;
2
The data along with a data Appendix A for annual exports to measure TI are publicly
available at Timothy Kehoe's webpage, http://www.econ.umn.edu/~tkehoe/research.
html.
j.jinteco.2014.01.007
where st, pt and pt denote the logarithms of their respective uppercase

variables. The real exchange rate is the price of one unit of domestic
goods in terms of foreign goods.
To measure exchange rate volatility volij between countries i and j,
we calculate the standard deviation of the monthly logarithms of the
bilateral real exchange rates over the one-year period for each currency
pair. (As a robustness check, we will also use different time windows
such as the three-year window and six-year window.) Specically,
volij is given by
"
volij
#
T
2
1 X
qij;t qij
;
T1 t1
1
2
max
tradeint X;Y;t
volij;t volij;t1 tradeint ij;t absidij;t
8
9
>
>
>
>
< export
export X;Y;t export Y;X;t =
X;Y;t export Y;X;t
X
X
max X
;X
;
>
export X;i;t
export i;X;t
export Y;i;t
export i;Y;t >
>
>
:
;
all
all
all
all
4
where exportX,Y,t is measured as free on board (f.o.b.) merchandise exports from country X to country Y at year t, measured in year t US dollars.
According to this denition, TI only needs to be high for one of the
two countries in the bilateral trade relationship. To see how to apply
this denition, consider for example the KoreaUS relationship.
With Korea accounting for just 5.3% of US trade, and the United
States accounting for 39.6% of Korean trade, tradeintmax
X,Y,t equals 39.6.
We also dene tradeintavg
X,Y,t as an alternative measure to Eq. (4). Instead
of picking the highest and discarding the lowest percentage, this
measure takes both percentages into account. More precisely,
average TI tradeintavg
X,Y,t between countries X and Y is dened as
avg
tradeint X;Y;t
8
9
>
>
>
>
< export
=
export
export
export
X;Y;t
X;Y;t
X Y;X;t
X Y;X;t
:
avg X
;X
>
>
export
export
export
export
>
>
X;i;t
i;X;t
Y;i;t
i;Y;t
:
;
all
regressions, however, are fraught with obvious endogeneity problems,

since causality between volatility and TI runs both ways. To address
this issue, in our preliminary regressions we employ an instrumental
variable (IV) estimation approach. Specically, we use the distance
between two countries as an instrument for TI. Clearly, distance
between two countries is exogenous and not determined by exchange
rate volatility. Moreover, distance is also an appropriate proxy variable
for TI sinceas predicted by gravity modelscountries that are closer
to each other tend to trade more. We thus estimate the following IV
panel regression equation,
where qij,t is the monthly logarithm of the bilateral real exchange rate
between countries i and j, and qij is the mean value of qij,t over a period
of T months.
We dene two alternative measures of TI, which aim to capture the
relative importance of a bilateral trade relationship as a fraction of each
country's total trade. Following Betts and Kehoe (2008), we dene the
maximum TI variable tradeintmax
X,Y,t between countries X and Y as follows
all
all
all
5
Thus, this measure averages the two fractions in the bilateral trade
relationship. If we apply the denition in Eq. (5) to the KoreaUS
example given above, we obtain 22.5% instead of 39.6% between Korea
and the United States. Both TI measuresaveraged over the period
19802005are reported in Table 1, panels (A) and (B) for all bilateral
avg
trade relationships. For tradeintmax
X,Y,t and tradeintX,Y,t most observations
are between 0 and 0.4, and between 0 and 0.2, respectively, with a
few outliers above these levels. In the analyses that follow, we will
therefore always verify that our results are not driven by these outliers.
In Fig. 1(A) and (B), we show scatter plots of exchange rate volatility
against TI (maximum) and TI (average), respectively, for the 91 currency pairs listed in Table 1. In addition to the presence of outliers, the
scatter plots show a negative correlation between volatility and both
TI measures.
3. Panel regressions with distance as an instrument
The scatter plots from Fig. 1 show a negative correlation between TI
and volatility, with the associated OLS regressions producing a negative
slope that is signicant at the 1% level for both TI measures.3 These
3
When we drop the USD/CAD or USD/MXN pair or both, the signicance remains at 1%
for average TI, but becomes 5% for the maximum TI measure.
N
1
X
di vij;t
i1
where is an intercept term, volij,t is exchange rate volatility, tradeintij,t

is TI (maximum) or TI (average), absidij,t is the absolute value of the
interest rate differential between two countries, i and j, di is a dummy
variable for each country i (N denotes the total number of countries),
and vij,t is an error term. Table 2 presents results from IV estimation
using panel data for the effects of TI on real exchange rate volatility.
Our estimates are negative and statistically signicant at the 1% level
for both measures of TI, maximum and average. Besides this main
nding, we also nd that exchange rate volatility increases with the
absolute value of interest rate differentials, which is consistent with
the view that carry tradeswhich are often seen as drivers of currency
trends and sharp reversalslead to an increase in volatility of the
exchange rates between investment and funding currencies.4
In Tables 3A, 3B, 3C, 3D, and 3E, we conduct a number of robustness checks for results from IV estimation using panel data: (a) we
drop/control for xed exchange rates, (b) we exclude outliers for the
real exchange rate volatility variable and the TI variable, (c) we subsample
by subperiods: 19801992 and 19932005, (d) we subsample by major
vs. minor, or exotic, currency pairs, and (e) we construct the volatility
variable using different time windows, in particular 3 and 6 years.
Regarding the rst robustness test (a), it is important to verify that,
since exchange rate stability is believed to promote trade, our results
are not primarily driven by the choice of exchange rate regime. In this
section, we follow IMF ofcial classications of regimes, as compiled
by Reinhart and Rogoff (2009). (In Section 4, we will revisit the issue,
focusing on de facto intervention rather than ofcially reported exchange rate regimes.) Most currencies in our sample are classied as
oating for most of the sample period, but there are a few exceptions.
Most importantly, in some years, a few countries pegged their currencies to trade-weighted indices, creating a negative link between trade
and volatility, almost by construction. This includes Norway and
Sweden over 198092 and Singapore over 19802005. We could not
nd a reasonable way to control for this, since adding a proxy measuring
the degree of xing proportionally to TI is akin to having TI twice. We
have thus excluded all pairs involving NOK, SEK, and SGD over the relevant years. In a few other casesnamely USD/KRW over 198096, USD/
MXN over 19801993, USD/TRY over 19801999, and CHF/EUR over
198081we encounter bilateral pegs. Following Reinhart and Rogoff
(2009) we include as xed all varieties of constant and crawling pegs
with bands no wider than 2%.5 We control for these cases using a
xed dummy variable. We report results from this robustness test in
Table 3A. While these changes somewhat reduce the absolute value of
the negative coefcient between TI and volatility, the coefcient remains signicant at the 1% level, and thus, our qualitative results
4
When we drop the interest rate differential, the negative relation between TI and exchange rate volatility remains unchanged.
5
Note that this denition excludes the well-known episode corresponding to Britain's
ERM membership over 198992. While the Pound was pegged to the German Mark, the
width of the band was 6%, and thus the regime is classied as oating.
j.jinteco.2014.01.007
Table 1
Trade intensity matrices.
Australia Canada
Germany Great Britain Japan
(A) Trade intensity (maximum) matrix

Australia
Canada
0.02601
Germany
0.06396 0.02146
Great Britain 0.08558 0.03660 0.31786
Japan
0.32536 0.05063 0.10273
Korea
0.07259 0.03115 0.06426
Mexico
0.00293 0.01976 0.03143
New Zealand 0.32575 0.02335 0.04520
Norway
0.00392 0.03894 0.22720
Singapore
0.06799 0.01110 0.07427
Sweden
0.01488 0.01783 0.31505
Switzerland
0.01346 0.01603 0.51414
Turkey
0.00901 0.01461 0.43699
United States 0.23868 0.86214 0.24199
0.08117
0.03861
0.01383
0.10231
0.31445
0.06522
0.20161
0.12076
0.13872
0.28871
(B) Trade intensity (average) matrix

Australia
Canada
0.01590
Germany
0.03996 0.02015
Great Britain 0.05618 0.03124
Japan
0.19591 0.04817
Korea
0.05802 0.02094
Mexico
0.00221 0.01374
New Zealand 0.20436 0.01234
Norway
0.00331 0.02219
Singapore
0.06602 0.00677
Sweden
0.01479 0.01088
Switzerland
0.01226 0.01013
Turkey
0.00603 0.00776
United States 0.12948 0.59842
0.06673
0.02910
0.01025
0.05530
0.19205
0.04358
0.13207
0.08290
0.07642
0.18303
0.28456
0.09314
0.04521
0.02268
0.02403
0.13365
0.04702
0.19629
0.33322
0.23547
0.16175
Korea
Mexico
New Zealand Norway Singapore Sweden Switzerland Turkey
0.33182
0.04977
0.20590
0.04263
0.29280
0.05280
0.06734
0.05691
0.51744
0.01008
0.03699
0.01477
0.07174
0.01292
0.01385
0.02526
0.39648
0.00768
0.00137
0.00489
0.00626
0.00794
0.00169
0.86181
0.00166
0.03538
0.00837
0.00764
0.00222
0.19756
0.00882
0.23248
0.01491
0.00783
0.09605
0.00897
0.01473
0.00867
0.37439
0.03654
0.02602 0.05658
0.15974 0.17966
0.21514
0.22051
0.03267
0.10829
0.02428
0.17784
0.03167
0.04181
0.03020
0.36772
0.00922
0.02128
0.01088
0.06003
0.01043
0.01195
0.01525
0.22461
0.00439
0.00098
0.00367
0.00494
0.00672
0.00099
0.49911
0.00114
0.02247
0.00526
0.00463
0.00195
0.10091
0.00741
0.19729
0.01181
0.00585
0.05076
0.00888
0.01409
0.00557
0.20369
0.03347
0.01757 0.03525
0.08643 0.09857
0.11025
United States
Note. Values for trade intensity (maximum) and trade intensity (average) averaged over the sample period 19802005 are reported.
continue to hold. Moreover, as expected, the coefcient associated with

the xed dummy is negative and signicant at the 1% level.6
Next, in Table 3B we truncate outliers of the dependent variable, real
exchange rate volatility, by excluding all observations that are more
than two standard deviations from the mean in any period t. This has
little impact on the results. Next, we also truncate outliers of the TI variable by excluding all observations that are included in the highest 2%
(this leads to dropping 52 observations for both TI (maximum) and TI
(average), respectively.). Truncating outliers of the TI variable also
leaves our results unaltered, as can be seen in Table 3B. Second, we
divide the entire sample period into two subperiods: 19801992
(rst half) and 19932005 (second half). As reported in Table 3C, the
slope coefcients for TI on volatility are greater in absolute value, i.e.,
more negative, in the rst half of the sample period. Qualitatively,
however, results are similar across both subperiods, with coefcients
remaining negative and signicant at the 1% level. Third, we investigate
whether our results are different for major currency crosses, which add
up to 42 out of our total of 91, and minor/exotic currency crosses, which
include the remaining 49 out of 91.7 This robustness test is driven by
potential concerns about volatility differences being driven by market
liquidity, which is greater for major currency pairs. As can be seen
from Table 3D, the results in both subsamples are almost exactly equal
to each other and to the overall results reported in Table 2. Finally, we
verify that our results are not sensitive to changing the width of the
time window in the denition of our volatility variable, set at 1 year in
6
In untabulated results, we also reran the regressions considering as xed and all possible combinations of pairs among KRW, MXN, and TRY, on the grounds that, if two currencies are pegged to the USD, they are pegged to each otheralthough in practice the bands
around the pegs signicantly weaken the degree to which pegging is transitive. In any
case, results were very similar to the baseline case.
7
The most traded currency pairs in the foreign exchange market are called the major
currency pairs. They involve the currencies such as Australian Dollar (AUD), Canadian Dollar (CAD), Euro (EUR), Great Britain Pound (GBP), Japanese Yen (JPY), Swiss Franc (CHF),
and US Dollar (USD). On the other hand, the minor/exotic currency pairs are dened as
those pairs that are emerging economies rather than developed countries.
the baseline regressions. Results with 3 and 6 year windows are reported in Table 3E. Clearly, the use of different time windows has virtually
no effect on the estimated coefcients for the other variables of interest.
Overall, the negative relationship between TI and exchange rate
volatility holds up well across the different robustness tests.
4. Estimation results from ESTAR models

While the previous section presents evidence that TI reduces exchange rate volatility, a related question is whether TI is also associated
with faster convergence of exchange rates to the values predicted by
relative PPP. To do this, we compare whether the half lives of PPP deviations differ between the set of 35 pairs with the highest TI and the set
of 35 pairs with the lowest TI.8 Given the evidence of nonlinearity in
mean reversion presented by Taylor et al. (2001), we compute halflives of PPP deviations using an exponential smooth transition
autoregressive (ESTAR) model.
While we provide details in the Appendix A, in broad strokes the
ESTAR model can be described as follows. There is a lower regime in
which PPP deviations are small. In this regime, persistence is mainly
governed by a parameter , which can be negative if there is mean
reversion, but can also be zero or positive, since unit root or explosive
dynamics are possible. As PPP deviations grow, however, there is a gradual shift to an upper regime in which persistence is governed by + *.
By assumption, the upper regime is mean reverting, and thus, it must be
that * b 0 and + * b 0. A transition function, parameterized by slope
parameter , determines the speed of transition from the lower to the
upper regime as PPP deviations grow. Standardized deviations are
given by qtd c2 = qtd , where qt d is the d-period lagged real
exchange rate, qtd is the standard deviation and the location parameter c is the estimated mean level that the exchange rate should revert to.
8
We use TI (average) to rank currency pairs. Using TI (maximum) instead of TI
(average) makes little difference.
j.jinteco.2014.01.007

Table 2
Effects of TI on real exchange rate volatility: IV estimation using panel data.
A)
SCATTER PLOT OF REAL EXCHANGE RATE

VOLATILITY AGAINST TRADE INTENSITY (MAXIMUM)
[1]
Real exchange rate volatility
0.1
at time t 1
TI (maximum)
0.08
VOL = 0.051 - 0.031 TI_max
(0.002) (0.008)
0.06
Interest rate differential in

absolute value
Intercept
0.034***
(0.004)
0.045***
(0.003)
2366
0.02
No. of observations
0.2
0.4
0.6
0.8
Trade intensity (maximum)
B) SCATTER PLOT OF REAL EXCHANGE RATE

VOLATILITY AGAINST TRADE INTENSITY (AVERAGE)
[2]
0.037***
(0.007)
TI (average)
0.04
0.056***
(0.011)
0.033***
(0.004)
0.045***
(0.003)
2366
[3]
[4]
0.121***
(0.021)
0.033***
(0.008)
0.122***
(0.021)
0.034***
(0.004)
0.039***
(0.003)
2275
0.050***
(0.012)
0.034***
(0.004)
0.039***
(0.003)
2275
Note. Results from IV estimation using panel data with country xed effects are reported.
The distance between two countries is used as an instrument to estimate the relationship
between trade intensity and real exchange rate volatility. The sample period is from
January 1980 to December 2005, and 91 currency pairs involving 14 countries are
included. The dependent variable is real exchange rate volatility. Standard errors are
reported in parentheses below the corresponding coefcients. Asterisks *, **, and ***
indicate 10%, 5%, and 1% statistical signicance, respectively.
0.1
bit involved. Tests to detect the presence of nonstationarity against

stationary STAR processes have been developed by Kapetanios et al.
(2003, KSS henceforth) and Bec et al. (2010, BBC henceforth). These
two tests compute Taylor series approximations to STAR models,
which have been used in the linearity test proposed by Saikkonen and
Luukkonen (1988) and get the auxiliary regressions
0.08
VOL = 0.051 - 0.051 TI_avg
(0.002) (0.012)
0.06
0.04
0.02
yt
r2
X
rr 1
0.2
0.4
0.6
0.8
r yt1 ytd
p
X
j yt j t ;
j1
Trade intensity (average)

Fig. 1. Scatter plots of real exchange rate volatility against trade intensity for 91 currency
pairs involving 14 countries over the period 19802005. The straight line is depicted by
running the ordinary least squares (OLS) regression. OLS estimates are reported above,
and the corresponding standard errors are in parentheses.
Further parameters 1,,p 1 and 1,,p 1 capture higher-order

persistence in the lower and upper regimes, respectively. Parameters
are estimated via nonlinear least squares (NLS).9
Having estimated the ESTAR model, we follow Koop et al. (1996) to
generate generalized impulse response functions (GIs). (See the
Appendix A for details.) The generated GIs are depicted in Fig. 2(A)
and (B). In the graphs, GIs for high TI currency pairs appear to decay
faster. This impression is conrmed when we calculate half-lives of
PPP deviations, which are reported in Table 4 for high and low TI
pairs. Typically, our estimates of the half-lives of deviations from PPP
for a given currency pair are higher the less intense the trade relationship between two countries. More specically, the average half-life in
the high TI group is shorter than the average half-life in the low TI
group by about 6.1 months. The t -statistic for the difference in means
test is 2.13, allowing us to reject the null hypothesis of no difference
in means.10 Thus, the half-lives of deviations from PPP based on the
estimations of the ESTAR models and the generated GIs suggest that
deviations from PPP are corrected faster for country pairs with relatively
more intense trade relationships.
It remains to be veried whether the nonstationarity of the ESTAR
model can be rejected. Although ( + *) b 0 is obtained for all pairs,
verifying the statistical signicance of the nonstationarity result is a
9
The estimation results along with the estimated transition functions, plotted against
time for high and low TI currency pairs are available from the authors upon request.
10
Although trade is endogenous to the real exchange rate, the differences in TI between
these two sets of country pairs very large and stable. In spite of dramatic movement in real
exchange rates throughout the sample period, TI for all low-intensity country pairs remain
far below any high-intensity pair at all times.
where t iid(0, 2). Both tests are performed by the statistical signi

cance of the parameters r1 ; ; r2 . Norman (2009) summarizes
both testing procedures, and extends to allow for a delay parameter, d,
that is greater than one. He shows that the distributions of both
statistics for d N 1 are the same as the case when d = 1. KSS set r1 =
r2 = 2, and derive the limiting non-standard distribution of the
t-statistic to test 2 = 0 against the null hypothesis of 2 b 0
t NL
^
2 :
s:e: ^2
BBC set r1 = 1, r2 = 2, and derive the limiting non-standard distribution of the Wald statistic, FNL, to test 1 = 2 = 0 against the null hypothesis of 1 0 or 2 0.11 Applying both tests to our currency
pairs with de-meaned data, we obtain t-values and F-values for the
KSS and BBC tests, respectively. Histograms of the obtained values are
plotted in Fig. 3. Out of 35 high TI currency pairs, KSS tests reject the
null in 1 case at the 1% level, 8 cases at the 5% level, and 5 cases at the
10% level. Out of 35 low TI pairs, KSS tests reject the null in 6 cases at
the 1% level, 6 at the 5% level, and 1 at the 10% level. The corresponding
numbers for BBC tests are 3 cases at the 1% level, 5 at the 5% level, and
6 at the 10% level for high TI pairs, and 6 cases at the 1% level, 5 at the
5% level, and 3 at the 10% level for low TI pairs. In terms of overall rejection rates for nonstationarity, these results are similar to those obtained
by KSS and BBC in their respective samples of real exchange rates. 12
11
KSS report 1%, 5%, and 10% asymptotical critical values in Table 1 on page 364. However, BBC do not provide any asymptotical critical values, and Norman (2009) reports the 5%
asymptotical critical value (10.13) using Monte Carlo simulations with 50,000 replications
in his paper. We thank Stephen Norman for providing us with 1% and 10% asymptotical
critical values for the BBC testing procedure.
12
KSS nd evidence that the tNL test rejects the null in 5 cases at the 5% signicance level
and another at the 10% signicance level out of 10 real exchange rates against the US Dollar. BBC conclude that the FNL test rejects the null in 11 cases out of 28 real exchange rates.
j.jinteco.2014.01.007
Table 3A
Effects of TI on real exchange rate volatility: Controlling for the exchange rate regime.
Robustness checks
Controlling for the exchange rate regime
[1]
[2]
Real exchange rate volatility at time t 1

0.031***
(0.008)
TI (maximum)
0.049***
(0.012)
0.035***
(0.005)
0.018***
(0.005)
0.035***
(0.005)
1653
TI (average)
Interest rate differential in absolute value
0.035***
(0.005)
0.017***
(0.005)
0.035***
(0.005)
1653
Fixed exchange rate regime dummy

Intercept
No. of observations
[3]
[4]
0.138***
(0.025)
0.029***
(0.008)
0.137***
(0.025)
0.045***
(0.012)
0.035***
(0.005)
0.017***
(0.005)
0.029***
(0.005)
1575
0.035***
(0.005)
0.015***
(0.005)
0.029***
(0.005)
1575
Note. Results from IV estimation using panel data with country xed effects are reported. We drop all pairs involving currencies linked to trade-weighted exchange rate indices. These
include AUD and NZD over 198083, SEK and NOK over 198092, and SGD over 19802005. We also include a xed dummy variable which takes on a value of one for currency
pairs, KRW/USD over 198096, MXN/USD over 198093, TRY/USD over 198099, and CHF/EUR over 198081 under the xed exchange rate regimes, and a value of zero, otherwise. Asterisks *, **, and *** indicate 10%, 5%, and 1% statistical signicance, respectively.
Table 3B
Effects of TI on real exchange rate volatility: Truncating outliers.
Robustness checks
Truncating outliers for real exchange rate volatility
[1]
[2]

TI (maximum)
0.045***
(0.006)
TI (average)
Intercept
No. of observations
0.017***
(0.003)
0.037***
(0.002)
2235
0.068***
(0.009)
0.017***
(0.003)
0.037***
(0.002)
2235
Truncating outliers for TI
[3]
[4]
0.139***
(0.016)
0.040***
(0.006)
0.140***
(0.016)
0.016***
(0.003)
0.052***
(0.003)
2147
[1]
[2]
0.040***
(0.011)
0.061***
(0.009)
0.016***
(0.003)
0.051***
(0.003)
2147
0.033***
(0.004)
0.045***
(0.003)
2314
0.055***
(0.017)
0.033***
(0.004)
0.061***
(0.004)
2314
[3]
[4]
0.127***
(0.021)
0.036***
(0.011)
0.124***
(0.021)
0.034***
(0.005)
0.039***
(0.003)
2225
0.049***
(0.017)
0.034***
(0.005)
0.052***
(0.005)
2225
Note. Results from IV estimation using panel data with country xed effects are reported. We truncate outliers for real exchange rate volatility, and outliers for TI, respectively. Asterisks *,
**, and *** indicate 10%, 5%, and 1% statistical signicance, respectively.
4.1. Half-lives and government intervention

We investigate whether the observed differences in volatility may be
due to Central Bank intervention in currency markets, or fear of oating,
instead of trade. To inquire into this issue, we follow in the footsteps of
Calvo and Reinhart (2002), using volatility of reserves and interest rates
as proxies for intervention.13 We then examine whether there is an
association between half-lives of deviations from PPP and our measures
of government intervention.
We denote the absolute value of the percent change in foreign
exchange reserves by |F|/F and the absolute value of the change in
interest rate by |it it 1|. Our rst intervention proxy is the frequency
with which |F|/F falls within a critical bound of 2.5%. The greater this
frequency, the less a country intervenes. This interpretation is straightforward, since purchases or sales of reserves are the most direct form of
intervention. For our second proxy, we interpret volatile interest rates
as evidence of attempts to stabilize the exchange rate. Thus, our second
variable is the percent of the time that interest rates change by 400 basis
points (4%) or more vis--vis the previous month. The more often this
occurs, the greater the degree of intervention. In Table 5, we report
the observed frequencies over the period January 1980December
13
These measures are admittedly very imperfect, as they fail to capture statements
about future policy, asset purchases (such as quantitative easing), and other tools used
by policymakers inuence currency markets. See Edison (1993) and Sarno and Taylor
(2001) for in depth discussions about proxies for intervention operations.
2008. By these two measures, Japan, Singapore and the United States
are examples of countries that tend to intervene least, whereas
Mexico and Turkey are among those that intervene most. To quantify
the overall degree of intervention, we simply rank the currencies, with
1 denoting the least intervened currency and 14 the most intervened.
Averaging a currency's two rank orders (one for reserves, one for interest rates), we obtain a currency's overall intervention level. To evaluate
the amount of intervention for a currency pair, we again average the
overall intervention levels of the two currencies in the pair.
Comparing intervention rankings for high versus low TI currency
crosses, we obtain an average of 5.32 for high TI currency pairs, and 8.19
for low TI pairs.14 This suggests that our half-life estimates are not mainly
driven by government intervention. If anything, intervention may reduce
the observed differences, if it successfully mitigates uctuations in the
low TI group.
5. Application to currency trading
We investigate whether our results can help predict exchange rates
and formulate protable currency trading strategies. To do this, we
must keep in mind that the returns of a strategy depend not only on exchange rate movements, but also on interest rates. This is partly due to
14
When we use percents instead of rank orders, there is little difference between high
and low TI currency pairs. The use of percents does not change our main results on government intervention.
j.jinteco.2014.01.007
Table 3C
Effects of TI on real exchange rate volatility: Subsamplingrst versus second half of sample period.
Robustness checks
Subperiod for 19801992
[1]
[2]

TI (maximum)
0.041***
(0.012)
TI (average)
Intercept
No. of observations
0.017**
(0.007)
0.039***
(0.005)
1183
0.063***
(0.018)
0.016**
(0.007)
0.040***
(0.005)
1183
Subperiod for 19932005

[3]
[4]
0.108***
(0.032)
0.038***
(0.012)
0.110***
(0.032)
[1]
[2]
0.032***
(0.009)
0.059***
(0.019)
0.011
(0.008)
0.053***
(0.005)
1092
0.012
(0.008)
0.053***
(0.005)
1092
0.044***
(0.006)
0.042***
(0.004)
1183
0.048***
(0.014)
0.044***
(0.006)
0.042***
(0.004)
1183
[3]
[4]
0.103***
(0.030)
0.028***
(0.010)
0.103***
(0.030)
0.044***
(0.006)
0.037***
(0.005)
1092
0.043***
(0.015)
0.044***
(0.006)
0.037***
(0.005)
1092
Note. Results from IV estimation using panel data with country xed effects are reported. The entire sample period is divided into two subperiods: 19801992 (a rst half) and 19932005
(a second half). Asterisks *, **, and *** indicate 10%, 5%, and 1% statistical signicance, respectively.
Table 3D
Effects of TI on real exchange rate volatility: Subsampling major vs. minor currency pairs.
Robustness checks
42 major currency pairs
[1]
[2]

TI (maximum)
0.035***
(0.006)
TI (average)
Intercept
No. of observations
0.201***
(0.021)
0.040***
(0.003)
1092
0.053***
(0.010)
0.199***
(0.021)
0.041***
(0.003)
1092
49 minor/exotic currency pairs

[3]
[4]
0.104***
(0.032)
0.031***
(0.007)
0.104***
(0.032)
0.184***
(0.022)
0.035***
(0.003)
1050
[1]
[2]
0.039***
(0.014)
0.047***
(0.010)
0.182***
(0.022)
0.037***
(0.004)
1050
0.030***
(0.005)
0.051***
(0.007)
1274
0.063***
(0.022)
0.030***
(0.005)
0.051***
(0.007)
1274
[3]
[4]
0.090***
(0.029)
0.039***
(0.014)
0.091***
(0.029)
0.032***
(0.005)
0.061***
(0.009)
1225
0.062***
(0.023)
0.031***
(0.005)
0.061***
(0.009)
1225
Note. Results from IV estimation using panel data with country xed effects are reported. 91 currency pairs are divided into 42 major and 49 minor/exotic currency pairs. Asterisks *, **, and
*** indicate 10%, 5%, and 1% statistical signicance, respectively.
Table 3E
Effects of TI on real exchange rate volatility: Dening volatility using different time windows.
Robustness checks
3-year window
[1]
6-year window
[2]

TI (maximum)
0.069***
(0.016)
TI (average)
Intercept
No. of observations
0.064***
(0.010)
0.070***
(0.007)
819
0.105***
(0.024)
0.063***
(0.010)
0.070***
(0.007)
819
[3]
[4]
0.038
(0.039)
0.058***
(0.017)
0.040
(0.039)
0.075***
(0.011)
0.054***
(0.007)
728
[1]
[2]
0.065***
(0.022)
0.088***
(0.026)
0.074***
(0.011)
0.055***
(0.008)
728
0.110***
(0.016)
0.096***
(0.009)
455
0.098***
(0.033)
0.109***
(0.016)
0.095***
(0.009)
455
[3]
[4]
0.062
(0.062)
0.048**
(0.024)
0.062
(0.062)
0.115***
(0.016)
0.051***
(0.010)
364
0.073***
(0.036)
0.114***
(0.016)
0.051***
(0.010)
364
Note. Results from IV estimation using panel data with country xed effects are reported. Volatility is computed over 3-year and 6-year periods. Asterisks *, **, and *** indicate 10%, 5%, and
1% statistical signicance, respectively.
the direct effect of interest differentials (minus bidask spreads) being

credited/debited daily to traders' accounts. But there is also an indirect
effect. As is well-known, contrary to what uncovered interest parity (UIP)
would predict, in the data high-interest currencies tend to appreciate. A
vast literature documents the positive average returns of the carry trade,
a strategy that prots from this anomaly by borrowing low-interest currencies to invest in high-interest ones.15 We thus adopt the carry trade as a
benchmark, and ask whether our ndings on mean reversion can help us
improve on this well-known strategy. Our exercise resembles that of
Jord and Taylor (2012), who also include PPP as a predictor in a sophisticated version of the carry trade.16 The novelty in our paper is that we also
explore whether gains from conditioning on PPP depend on TI.
For the currencies in our sample over the period January 1986
December 2012, we compare a plain carry trade strategy with an
15
The protability of carry trades has been documented by Brunnermeier et al. (2008)
and Burnside et al. (2006) among many others. While the failure of UIP has long been referred to as the forward premium puzzle, recent work by Lustig et al. (2011) and Menkhoff
et al. (2012) has gone a long way towards reconciling the protability of carry trades with
standard asset pricing theory by identifying risk factors that explain excess returns.
16
In addition to Jord and Taylor (2012), there have been other approaches seeking to
improve the performance of carry trade, mostly by reducing risk. For instance, some authors have proposed diversication (Burnside et al., 2006), the use of options (Burnside
et al., 2011).
j.jinteco.2014.01.007
augmented one. The plain strategy enters a trade (long currency A,

short currency B) if the interest rate differential iAt iBt exceeds a threshold spread i t , i.e., if
A
it it i t :
We experiment with four specications of the threshold i t . In the

rst three, it is constant at 1, 2, or 3%. In the fourth, we consider an interest differential to be high only if it is higher than others available at the
time. Thus, we set i t equal to imed
imin
, the difference between the
t
t
median and minimum interest rates in our sample. For a currency
Fig. 2. (A) GIs for 35 highest TI currency pairs. (B) GIs for 35 lowest TI currency pairs.
j.jinteco.2014.01.007
Fig. 2 (continued).
pair, if the difference between the higher and the lower interest rates is
less than i t , the strategy is inactive and no trade is entered.
The augmented carry strategy buys currency A against B if, in
addition to the interest condition (7) being satised, currency A
is undervalued vis--vis currency B in the following sense. The 12-
month lagged real exchange rate QAB,t 12 (i.e., the price of A's goods
relative to B's goods) times a factor must be below the long-run
average Q AB;t . That is,
Q AB;t12 Q AB;t :
j.jinteco.2014.01.007
10
Table 4
Half-life estimates for real exchange rates.
High TI currency pairs
Low TI currency pairs

Half-life
USD/CAD
USD/MXN
USD/JPY
CHF/EUR
GBP/EUR
TRY/EUR
USD/KRW
KRW/JPY
NZD/AUD
USD/SGD
SEK/NOK
SEK/EUR
JPY/AUD
GBP/NOK
USD/GBP
SGD/JPY
USD/EUR
NOK/EUR
GBP/SEK
USD/AUD
USD/TRY
NZD/JPY
USD/NZD
USD/CHF
JPY/EUR
USD/SEK
GBP/CHF
GBP/TRY
GBP/JPY
SGD/AUD
SGD/KRW
KRW/AUD
GBP/AUD
GBP/NZD
USD/NOK
Average
32
16
31
5
26
24
7
13
35
56
36
15
22
3
14
25
15
6
12
17
39
24
19
18
27
18
27
17
31
16
1
4
21
12
23
20.20
Half-life
TRY/SEK
CAD/AUD
TRY/KRW
SEK/AUD
CHF/SGD
MXN/CAD
NZD/CAD
CHF/AUD
CHF/KRW
CHF/NOK
SEK/CAD
NOK/KRW
SEK/KRW
GBP/MXN
CHF/CAD
MXN/KRW
SEK/SGD
TRY/CAD
SGD/NOK
SGD/CAD
CHF/MXN
TRY/AUD
TRY/NOK
TRY/SGD
SEK/NZD
SEK/MXN
CHF/NZD
NZD/MXN
SGD/MXN
NOK/AUD
MXN/AUD
TRY/NZD
NOK/NZD
TRY/MXN
NOK/MXN
23
11
43
12
29
28
35
36
17
23
21
7
12
17
41
22
19
33
28
53
21
39
41
32
23
49
6
24
26
16
27
27
6
27
48
26.34
Note. The half-life is measured as the discrete number of months taken until the shock to
the level of the real exchange rate has fallen below half.
margin. For example, if = 3/2, Eq. (8) holds only if A is so undervalued

that the (lagged) real exchange rate is below 2/3 of its long-term average. As continues to increase, the PPP becomes more stringent, and in
the limit it is never satised, meaning that the augmented PPP strategy
is always idle.19
The augmented carry ( N 0) is more selective than the plain carry
( = 0), since it requires more conditions and enters fewer trades. The
key trade-off when choosing is as follows. A higher tends to raise the
average protability of the trades entered, but it also means that, by
entering fewer trades, investors forego opportunities to prot from
interest differentials and diversify their portfolio. To nd the optimal
levels of , we evaluate the performance of the plain and augmented
strategies separately for the set of 35 high and 35 low TI currency
pairs from Table 4. To compute the returns of the plain carry, for every
currency pair, we check whether the interest rate condition (7) is
satised. If yes, the pair is active. If not, it is inactive. The return of an
active pair is given by
Rt1
"
#
SAB;t1
i A iB tc
1 t1 t1
;
SAB;t
12
where SAB,t is the nominal exchange rate measured as the price of one
unit of currency A in terms of currency B, and tc is a transaction cost,
set at 1% per annum.20 The return of an inactive pair is zero. The portfolio
return RPF
t + 1 (for high and low TI), is the equally weighted average of the
returns of active pairs. If no pairs are active, the portfolio return RPF
t + 1 is
zero. To simulate the augmented carry we follow the same steps, with
the only difference being thatas explained abovea pair must satisfy
both the interest rate condition (7) and the PPP condition (8) to be
active.
For each strategy, we compute 27 years of monthly returns from
January 1986 to December 2012. To evaluate performance, we focus
on the annualized Sharpe ratio dened as

Mean RPF p
12;
Sharpe
SD RPF
10
The factor captures the degree to which currency A must be

undervalued to enter a trade. If = 0, the PPP condition (8) always
holds, and the augmented carry strategy is just the plain carry. As
increases, Eq. (8) becomes more stringent, allowing fewer trades. If
b 1, Eq. (8) allows currency A to be bought as long as it is not too
overvalued. For instance, if = 2/3, currency A can be bought against
B even if it is a bit expensive; specically, as long as it is less than 50%
overvalued. If = 1, condition (8) holds only if A is undervalued relative
to B. Finally, if N 1, A can only be bought if undervalued by a given
p
where multiplying by 12 converts a monthly ratio into an annual one.
The evolution of Sharpe ratios as a function of is plotted in Fig. 4 for
all specications of i t . The case with = 0 corresponds to the plain
carry. For b 0.5, PPP deviations in the sample are too small to violate
the PPP condition, and the augmented carry remains the same as the
plain one. Starting at around = 0.5 for low TI and 0.6 for high TI, we
start nding cases where the high-interest currency is overvalued
enough to violate the PPP condition. The PPP condition deactivates
these trades, which tends to raise Sharpe ratios, especially in the low
TI group. Sharpe ratios increase for between approximately 0.6 and
0.95 in the high TI group and 0.5 and 1 in the low TI group. Beyond
0.95, or 1, increases in tend to lower Sharpe ratios, as the opportunity
cost from foregoing a growing number of trades outweighs the gains
from increased average quality of trades. This decline is more pronounced in the high TI group. In sum, gains from augmenting the
carry strategy are typically greater in the low TI portfolio, because
there is a wider range of values of for which the augmented carry outperforms the plain carry, and because there is typically a higher
17
We have chosen a 12 month lag after experimenting with multiple specications.
While the best lags seem to range between 9 and 15 months, results are still qualitatively
similar for lags between 6 and 24 months, and worsen substantially outside this range.
18
We use data on real exchange rates from January 1971 to December 1985 to compute
the initial average real exchange rate. Experimenting with the number of lags in the moving average, we nd that, as the number of lags rises, the moving average becomes more
stable and useful as a predictor. These gains, however, peter out as the number of lags
grows. On the other hand, more lags mean losing more observations at the start of the
sample period, because they are needed to compute the rst moving average. Our choice
of 15 years balances these two effects. As long as the moving average contains at least
10 years, results remain fairly similar.
19
It is important to note that, although it involves a moving average, the augmented PPP
carry is not a momentum strategy. Momentum strategies buy currencies when the exchange rate is greater than its moving average. The simplest example is Buy if St N MA(1),
which is equivalent to Buy if St N St 1. Our PPP conditionespecially for high values of
does the opposite, buying currencies that have substantially depreciated, i.e., buying
when the exchange rate is below the moving average.
20
In spot foreign exchange markets, transaction costs include a bidask spread applied
at the level of the exchange rate, and another bidask spread applied to the interest rates.
These spreads are different across time periods, currency pairs, and brokers. We have chosen 1% per annum as a rough average based on spreads charged by forex brokers such as
OANDA, FXCM, and others.
The use of a lagged real exchange rate captures the idea behind
the J-curve, i.e., that it takes some time for exchange rate misalignments
to inuence trade.17 As a measure of the long-run average, we compute
real exchange rate's 15-year moving average.18
180
X
Q AB;t
Q AB;ts
s1
180
j.jinteco.2014.01.007
11
12
USD/KRW
JPY/AUD
USD/GBP
CHF/EUR
USD/NZD
SGD/AUD TRY/EUR
GBP/AUD KRW/JPY
GBP/NZD SEK/EUR
JPY/EUR
USD/SEK
USD/CAD
SEK/NOK
GBP/NOK
USD/EUR
NOK/EUR
GBP/SEK
USD/AUD
NZD/JPY
USD/CHF
GBP/CHF
GBP/JPY
SGD/KRW
10
USD/MXN
USD/JPY
GBP/EUR
USD/SGD
SGD/JPY
USD/TRY
GBP/TRY
KRW/AUD
USD/NOK
-3.48<t
<-2.93
(5%)
CHF/KRW
NOK/KRW
SEK/KRW
GBP/MXN
CHF/MXN
NOK/NZD
NZD/AUD
t<-3.48
(1%)
12
-2.93<t -2.66<t<-2 -2<t<-1

<-2.66
(10%)
0
0<t<1 1<t<2 2<t<3 3<t<4
-1<t<0
t<-3.48
(1%)
(A) KSS TEST RESULTS FOR HIGH TI PAIRS
12
CAD/AUD
SEK/AUD
SEK/NZD
CHF/NZD
NZD/MXN
NOK/AUD
-3.48<t
<-2.93
(5%)
10
TRY/SEK
TRY/KRW
CHF/SGD
MXN/CAD
CHF/CAD
SGD/CAD
TRY/NOK
TRY/SGD
MXN/AUD
2
SEK/CAD
TRY/CAD
-2.93<t -2.66<t<-2 -2<t<-1

<-2.66
(10%)
-1<t<0
0
0<t<1 1<t<2 2<t<3 3<t<4
(B) KSS TEST RESULTS FOR LOW TI PAIRS
12
TRY/EUR
SEK/NOK
SEK/EUR
USD/EUR
NOK/EUR
GBP/SEK
USD/AUD
USD/TRY
USD/CHF
JPY/EUR
GBP/CHF
USD/NOK
10
8
6
4
2
USD/SGD
KRW/AUD
NZD/CAD
CHF/AUD
CHF/NOK
MXN/KRW
SEK/SGD
SGD/NOK
TRY/AUD
SEK/MXN
SGD/MXN
TRY/NZD
TRY/MXN
NOK/MXN
0<F<2
USD/JPY
GBP/EUR
SGD/JPY
2<F<4
USD/CAD
GBP/NOK
NZD/JPY
GBP/JPY
4<F<6
10
8
6
USD/MXN
JPY/AUD
USD/SEK
SGD/AUD
SGD/KRW
GBPNZD
6<F<8.57
8.57<F
<10.13
(10%)
USD/GBP
CHF/EUR
USD/NZD
GBP/TRY
GBP/AUD
10.13<F
<13.79
(5%)
4
USD/KRW
KRW/JPY
NZD/AUD
13.79<F
(1%)
(C) BBC TEST RESULTS FOR HIGH TI PAIRS
MXN/CAD
CHF/CAD
SGD/CAD
MXN/AUD
2
0
TRY/KRW
NZD/CAD
TRY/AUD
TRY/NOK
SEK/MXN
NOK/MXN
TRY/SEK
CHF/SGD
CHF/NOK
MXN/KRW
SEK/SGD
SGD/NOK
TRY/SGD
SGD/MXN
TRY/NZD
TRY/MXN
SEK/CAD
SEK/NZD
NZD/MXN
CAD/AUD
SEK/AUD
CHF/AUD
GBP/MXN
CHF/NZD
CHF/KRW
NOK/KRW
SEK/KRW
CHF/MXN
NOK/AUD
NOK/NZD
TRY/CAD
0<F<2
2<F<4
4<F<6
6<F<8.57
8.57<F
<10.13
(10%)
10.13<F
<13.79
(5%)
13.79<F
(1%)
(D) BBC TEST RESULTS FOR LOW TI PAIRS
Fig. 3. KSS and BBC test results for high and low TI pairs.
maximum gain in Sharpe ratio relative to the plain carry. The optimal
level of is also higher in the low TI group. Specically, Sharpe ratios
peak for = 0.95, 0.95, 0.97, and 0.95 in the high TI group and 1, 1, 1,
and 1.14 in the low TI group, for i t respectively equal to 1%, 2%, 3%,
and imed
imin
t
t . These optimal values of , along with peak Sharpe ratios,
are reported in Table 6, panel (A). For both high and low TI, in all four
specications of i t , the Sharpe ratio for the augmented carry is higher
than for the plain carry. Gains from conditioning on PPP are also
displayed in Fig. 5, where we plot the evolution of 1 dollar over time
Table 5
Proxies for ofcial intervention.
Probability that the monthly change is
Within a 2.5% band:
Greater than 4% (400 basis points):
Country
Reserves
Nominal interest rate
Australia
Canada
Euro Area
Great Britain
Japan
Korea
Mexico
New Zealand
Norway
Singapore
Sweden
Switzerland
Turkey
United States
39.37
43.97
66.09
60.63
81.03
49.14
41.38
23.85
38.22
78.74
38.79
45.40
30.46
68.39
0.00
1.72
0.00
0.00
0.00
0.57
14.66
2.01
0.29
0.00
1.44
0.29
29.89
0.29
Note. Indicators of foreign exchange reserves volatility and interest rate volatility over the
period January 1980December 2008.
under both strategies. In the high TI case, the augmented carry earns
higher average returns than the plain carry. Moreover, the augmented
strategy is less risky, largely avoiding the 2008 crash suffered by the
plain carry. In the low TI case, the augmented carry's mean return surpasses the plain carry's by an even wider margin than in the high TI
case, while volatility is similar for both strategies.21
This in-sample comparison, however, may exaggerate the benets of
conditioning on PPP, because is chosen with the benet of hindsight. A
fairer test is to compare both strategies out-of-sample. To simulate the
out-of-sample augmented carry, we consider a hypothetical investor
whofor each year t {1994,,2012}chooses at the start of the
year using only the data available up to that point. That is, the investor
sets at the level that maximizes the augmented carry's Sharpe ratio
over the period January 1986December t 1, and updates yearly.
For both high and low TI, and for all four specications of the interest
rate condition, the out-of-sample values of uctuate within a relatively narrow range of the in-sample values reported above, with the maximizing value of being higher in the low TI group most years. Using
these values of , we simulate the augmented carry over the period January 1994December 2012, and report performance statistics in Table 6
(B). As expected, the gains from conditioning on PPP weaken to some
extent, especially in the high TI case. For i t 3%, and i t imed
imin
t
t ,
out-of-sample results are similar to in-sample results. The augmented
21
Due to the composition of the two groups, the 2008 carry crash is less pronounced for
low TI. The high TI group includes many major/minor pairs, such as USD/MXN, or USD/TRY.
The low TI group, on the other hand, contains many minor/minor pairs, such as MXN/TRY.
In the crash, there was a sharp unwinding of carry trades in the high TI group, as investors
rushed to the safety of the USD. On the other hand, in the low TI group, all minor currencies
were falling and therefore the overall effect was much more muted.
j.jinteco.2014.01.007
12
(A)
Aunnualized Sharpe ratio
1.4
High TI
Low TI
1.2
1
0.8
0.6
0.4
0.2
0
-0.2
-0.4
0
0.2
0.4
0.6
0.8
1.2
1.4
1.6
1.8
Threshold ()
(B)
lower Sharpe ratios. Inspecting all cases together in Fig. 6(A), the
augmented carry comes out slightly behind in the rst two graphs,
but clearly ahead in the third and fourth. In the low TI case, results remain favorable to the augmented carry. As reported in Table 6(B), the
augmented carry has higher Sharpe ratios than the plain carry for
three out of four specications of the interest rate condition, and higher
mean returns for all four specications. This is clearly visible in Fig. 6(B),
where the augmented carry nishes ahead of the plain carry in all four
plots.
Overall, we nd conditioning on PPP to be more useful in the low TI
portfolio, where exchange rates tend to deviate further from long-run
values. This raises potential losses from wrong predictions and gains
from correct ones, as compared with the high TI case. Since interest
differentials are similar in both groups, staying out of trades has a
similar opportunity cost, while predicting larger swings in the low TI
case provides a greater benet.
1.4
1.2
6. Conclusion
1
0.8
0.6
0.4
0.2
0
-0.2
-0.4
0
0.2
0.4
0.6
0.8
1.2
1.4
1.6
1.8
1.4
1.6
1.8
Threshold ()
(C)
1.4
1.2
1
0.8
0.6
0.4
0.2
0
-0.2
-0.4
0
0.2
0.4
0.6
0.8
1.2
Threshold ()
(D)
1.4
1.2
1
This paper explores the interaction between exchange rate volatility

and fundamentals by examining the role of TI in the reversion of exchange rates to long-run equilibrium values, as given by purchasing
power parity (PPP). Following the recent literature on nonlinearity,
we estimate an ESTAR model, which allows the speed at which
exchange rates converge to their long-run equilibrium to depend on
the size of the deviations. We nd estimates of the half-lives of deviations from PPP to be higher the less intense the trade relationship
between two countries. These results continue to hold as we perform
a series of robustness tests, such as including/excluding interest rates
as explanatory variables, focusing on different subsamples, and
experimenting with different window widths to compute volatility.
When including interest rates, we nd that exchange rate volatility
increases with the absolute value of interest rate differentials, which is
consistent with the notion that carry trades tend to exacerbate uctuations in currency markets. We also verify that the faster convergence to
equilibrium values observed for high TI pairs does not appear to be
driven by Central Bank intervention. Finally, we investigate whether
our ndings can be useful to improve the performance of a wellknown currency trading strategy, the carry trade. We consider strategies that combine a carry-trade componentinvesting in high-interest
rate currencieswith a fundamental componentpurchasing currencies only if undervalued according to relative PPP. Our ndings suggest
that an augmented carry trade strategy that conditions on PPP fundamentals tends to perform betterin terms of higher Sharpe ratios
than a plain carry strategy which blindly chases interest rate differentials. These ndings hold in- and out-of-sample, although they are a
bit weaker in the latter case. Gains from conditioning on PPP are
generally greater for low TI currency pairs.
0.8
Acknowledgments
0.6
0.4
0.2
0
-0.2
-0.4
0
0.2
0.4
0.6
0.8
1.2
1.4
1.6
1.8
Threshold ()
Fig. 4. Annualized Sharpe ratios as a function of the PPP threshold ().
carry is clearly superior to the plain carry, both due to higher returns
and lower risk, most notably at the time of the 2008 crash. However,
for i t 1% and i t 2%, the augmented carry has similar volatility
and slightly lower returns than the plain carry, resulting in a mildly
This paper has beneted from discussion with or comments by

Richard Baillie, Kirt Butler, Jinill Kim, Seunghwa Rho as well as by the
Editor, Eric van Wincoop, and two anonymous referees. We would also
like to thank participants at Yonsei University, Korea University, the
2010 Midwest Macroeconomics Meetings, 2010 Midwest Econometrics
Group Annual Meetings, and 2011 Eastern Finance Association Annual
Meetings, 2012 Econometric Society's North American Summer Meetings, and 2012 Australasian Meeting of Econometric Society for helpful
comments. Any remaining errors are solely the authors' responsibility.
Appendix A
In this appendix, we briey introduce the ESTAR model, and describe
how to estimate half-lives of deviations from PPP.
j.jinteco.2014.01.007
13
Table 6
Summary statistics for carry trade portfolios.
(A) In-sample: Jan. 1986Dec. 2012
i t 1%
Average 1 month return

Standard deviation
Annualized Sharpe ratio
i t 2%
i t imed
imin
t
t
i t 3%
Plain
Augmented
Plain
Augmented
Plain
Augmented
Plain
Augmented
=0
= 0.95
=0
= 0.95
=0
= 0.97
=0
= 0.95
0.377%
0.016
0.811
0.450%
0.017
0.930
0.465%
0.019
0.860
0.562%
0.018
1.058
0.518%
0.021
0.858
0.622%
0.020
1.086
0.633%
0.024
0.918
0.724%
0.021
1.197

i t 1%

Standard deviation
i t 2%
i t imed
imin
t
t
i t 3%
Plain
Augmented
Plain
Augmented
Plain
Augmented
Plain
Augmented
=0
=1
=0
=1
=0
=1
=0
= 1.14
0.432%
0.017
0.871
0.618%
0.018
1.190
0.495%
0.019
0.904
0.664%
0.020
1.140
0.550%
0.021
0.892
0.747%
0.022
1.153
0.626%
0.024
0.901
0.775%
0.027
0.984
(B) Out-of-sample: Jan. 1994Dec. 2012

i t 1%

Standard deviation
i t 2%
i t imed
imin
t
t
i t 3%
Plain
Augmented
Plain
Augmented
Plain
Augmented
Plain
Augmented
=0
Varying
=0
Varying
=0
Varying
=0
Varying
0.424%
0.018
0.825
0.399%
0.018
0.778
0.530%
0.021
0.876
0.509%
0.021
0.832
0.578%
0.024
0.851
0.629%
0.023
0.966
0.681%
0.027
0.884
0.749%
0.022
1.159

i t 1%

Standard deviation
i t 2%
Plain
Augmented
Plain
Augmented
Plain
Augmented
Plain
Augmented
=0
Varying
=0
Varying
=0
Varying
=0
Varying
0.462%
0.019
0.859
0.542%
0.018
1.068
0.537%
0.021
0.891
0.547%
0.021
0.924
0.612%
0.024
0.890
0.713%
0.025
1.003
0.696%
0.026
0.911
0.723%
0.033
0.770
A.1. The ESTAR model

The regime-switching model known as Smooth Transition Autoregressive (STAR), was developed by Granger and Tersvirta (1993)
and Tersvirta (1994). In this model, adjustment takes place every
period but the speed of adjustment varies with the extent of the
deviation from equilibrium. When reparameterized in rst difference
form, the STAR model for the real exchange rate qt can be written as
qt qt1
p1
X
j1
2
i t imed
imin
t
t
i t 3%
j qt j 4 qt1
p1
X
3
j qt j 5qtd ; ; c t
j1
11
where qt j = qt j qt j 1, {qt} is a stationary and ergodic process,
t iid(0, 2), and () is the transition function that determines
the degree of mean reversion and itself governed by the parameter
, which determines the speed of mean reversion to PPP. The delay
parameter d (N 0) is an integer. The ESTAR model is the variant
of the STAR model where transition is governed by the exponential
function
h
2
qtd ; ; c 1exp qtd c = qtd
restriction on the parameter ( N 0) is an identifying restriction. The exponential function in Eq. (12) is bounded between 0 and 1, and depends
on the transition variable qt d. The values taken by the transition variable qt d and the transition parameter together will determine the
speed of mean reversion to PPP.22 ESTAR models are estimated by nonlinear least squares (NLS), with the starting values obtained from a grid
search over and c. The estimations are also implemented with the selected lag order p and delay parameter d which are suggested by the
partial autocorrelation function (PACF) and the linearity tests results,
respectively, for both high and low TI currency pairs.
with N0
12
where qt d is a transition variable, qtd is the standard deviation of

q t d, is a slope parameter, and c is a location parameter. The
A.2. Estimation of half-lives of deviations from PPP

We investigate the dynamic adjustment in response to the shock of
the estimated ESTAR model by computing generalized impulse
response functions. The generalized impulse response function (GI),
proposed by Koop et al. (1996) avoids the problem of using future information by taking expectations conditioning only on the history and on
the shock. GI may be considered as the realization of a random variable
dened as

GIq h; t ; t1 E qth jt ; t1 E qth jt1
13
22
For any given value of qt d, the transition parameter determines the slope of the
transition function, and thus the speed of transition between two regimes, with low values
of implying slower transitions.
j.jinteco.2014.01.007
14
(B) LOW TI CURRENCY PAIRS
(A) HIGH TI CURRENCY PAIRS

9
9
Plain Carry
Augmented Carry
86 88 90 92 94 96 98 00 02 04 06 08 10 12
86 88 90 92 94 96 98 00 02 04 06 08 10 12
11
11
86 88 90 92 94 96 98 00 02 04 06 08 10 12
86 88 90 92 94 96 98 00 02 04 06 08 10 12
13
13
11
11
86 88 90 92 94 96 98 00 02 04 06 08 10 12
86 88 90 92 94 96 98 00 02 04 06 08 10 12
13
13
11
11
86 88 90 92 94 96 98 00 02 04 06 08 10 12
86 88 90 92 94 96 98 00 02 04 06 08 10 12
Fig. 5. In-sample performance of carry trade portfolios (Jan. 1986Dec. 2012): evolution of one dollar over time.
for h = 0,1,2. In Eq. (13), the expectation of qt + h given that the shock
occurs at time t is conditional only on the history and on the shock. We
generate GI functions using the Monte Carlo integration method
developed by Gallant et al. (1993). For the history and the initial
shock, we compute GIq(h, , t 1) for horizons h =0,1,2,100. The
conditional expectations in Eq. (13) are estimated as the means over
j.jinteco.2014.01.007
(A) HIGH TI CURRENCY PAIRS
15
(B) LOW TI CURRENCY PAIRS

4
4
Plain Carry
Augmented Carry
94
96
98
00
02
04
06
08
10
12
94
94
96
98
00
02
04
06
08
10
12
94
94
96
98
00
02
04
06
08
10
12
94
94
96
98
00
02
04
06
08
10
12
94
96
98
00
02
04
06
08
10
12
96
98
00
02
04
06
08
10
12
96
98
00
02
04
06
08
10
12
96
98
00
02
04
06
08
10
12
Fig. 6. Out-of-sample performance of carry trade portfolios (Jan. 1994Dec. 2012): evolution of one dollar over time.
2000 realizations of qt + h, accomplished by iterating on the ESTAR

model, with and without using the selected initial shock to obtain qt
and using randomly sampled residuals of the estimated ESTAR model
elsewhere. Impulse responses for the level of the real exchange rate, qt
are obtained by accumulating the impulse responses for the rst differences. The initial shock is normalized to 1, and the half-lives of real
j.jinteco.2014.01.007
16
exchange rates to the shock are calculated by measuring the discrete

number of months taken until the shock to the level of the real
exchange rate has fallen below half.
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Trading Intensity

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INEC-02750; No of Pages 16

Journal of International Economics xxx (2014) xxxxxx

Contents lists available at ScienceDirect

Journal of International Economics

Trade intensity and purchasing power parity

Department of Economics, Kookmin University, Seoul 136-702, Republic of Korea

D. Cho, A. Doblas-Madrid / Journal of International Economics xxx (2014) xxxxxx

dependent variable and TI as one of our independent variables, using

D. Cho, A. Doblas-Madrid / Journal of International Economics xxx (2014) xxxxxx

where st, pt and pt denote the logarithms of their respective uppercase

volij;t volij;t1 tradeint ij;t absidij;t

regressions, however, are fraught with obvious endogeneity problems,

where is an intercept term, volij,t is exchange rate volatility, tradeintij,t

D. Cho, A. Doblas-Madrid / Journal of International Economics xxx (2014) xxxxxx

Germany Great Britain Japan

(A) Trade intensity (maximum) matrix

(B) Trade intensity (average) matrix

New Zealand Norway Singapore Sweden Switzerland Turkey

continue to hold. Moreover, as expected, the coefcient associated with

4. Estimation results from ESTAR models

D. Cho, A. Doblas-Madrid / Journal of International Economics xxx (2014) xxxxxx

SCATTER PLOT OF REAL EXCHANGE RATE

Real exchange rate volatility

Interest rate differential in

Trade intensity (maximum)

B) SCATTER PLOT OF REAL EXCHANGE RATE

Real exchange rate volatility

bit involved. Tests to detect the presence of nonstationarity against

Trade intensity (average)

Further parameters 1,,p 1 and 1,,p 1 capture higher-order

D. Cho, A. Doblas-Madrid / Journal of International Economics xxx (2014) xxxxxx

Real exchange rate volatility at time t 1

Fixed exchange rate regime dummy

Real exchange rate volatility at time t 1

Truncating outliers for TI

4.1. Half-lives and government intervention

D. Cho, A. Doblas-Madrid / Journal of International Economics xxx (2014) xxxxxx

Real exchange rate volatility at time t 1

Subperiod for 19932005

Real exchange rate volatility at time t 1

49 minor/exotic currency pairs

Real exchange rate volatility at time t 1

the direct effect of interest differentials (minus bidask spreads) being

D. Cho, A. Doblas-Madrid / Journal of International Economics xxx (2014) xxxxxx

augmented one. The plain strategy enters a trade (long currency A,

We experiment with four specications of the threshold i t . In the

D. Cho, A. Doblas-Madrid / Journal of International Economics xxx (2014) xxxxxx

D. Cho, A. Doblas-Madrid / Journal of International Economics xxx (2014) xxxxxx

Low TI currency pairs

margin. For example, if = 3/2, Eq. (8) holds only if A is so undervalued

The factor captures the degree to which currency A must be

D. Cho, A. Doblas-Madrid / Journal of International Economics xxx (2014) xxxxxx

-2.93<t -2.66<t<-2 -2<t<-1

(A) KSS TEST RESULTS FOR HIGH TI PAIRS

-2.93<t -2.66<t<-2 -2<t<-1

(B) KSS TEST RESULTS FOR LOW TI PAIRS

(C) BBC TEST RESULTS FOR HIGH TI PAIRS

(D) BBC TEST RESULTS FOR LOW TI PAIRS

Greater than 4% (400 basis points):

Nominal interest rate

D. Cho, A. Doblas-Madrid / Journal of International Economics xxx (2014) xxxxxx

Aunnualized Sharpe ratio

This paper explores the interaction between exchange rate volatility

This paper has beneted from discussion with or comments by