How the Federal funds target rate announcement affects the foreign exchange rate? The case of US dollar and Euro

Abstract

Recently the issue as to whether federal funds target rates will rise or remain stable has become popular Changes in the federal funds target rate will not only influence the short rate in the market but will also affect overall economic conditions How exchange rates in the U S and Europe will change when the federal funds target rate fluctuates is a very interesting topic Moreover we combine the stochastic movement of term structure - one factor Cox-Ingersoll-Ross (CIR) model with interest rate parity to conduct our research We set the federal funds target rates announcement as the basis date use ex ante six business day information and strips (Separate Trading of Registered Interest and Principal of Securities) to calibrate the CIR parameters and estimate the U S and Euro ex post interest rates We then use the interest rate parity to transfer the estimated interest rates into exchange rates The sample data is from June 21 2006 to April 8 2016 Furthermore we measure the model of predictive power compare it with alternative models and choose the best prediction model In our results we find that exchange rates don’t have same direction when the federal funds target rate changes which might cause interest rates for the euro area to change after the interest rate in the U S changes Furthermore the CIR model is better than using only the IRP model and federal funds target rate as the instantaneous rate in the CIR model because it is more precise

Date of Award	2016 Jun 23
Original language	English
Supervisor	Tse-Shih Wang (Supervisor)