USD, Turkish Lira and Purchasing Power Parity Case Study And Analysis Help With Solution

Case – USD, Turkish Lira and Purchasing Power Parity.

Veritas Emerging Market Fund, LLC specializes in investing in the world’s emerging stock markets. Mr. Henry Guessright (the same person as in Choice # 1) is an experienced hand at the firm; he is also your boss. He is currently interested in the Turkish stock market. He correctly anticipated, back in 2004-2005, that Turkey would be invited to negotiate its membership in the European Union and that this development would boost the stock market in Turkey.

Ten years later, as of late Fall 2014, he is quite concerned with the potential for exchange rate volatility in Turkey and would like to understand what has historically driven Turkish exchange rates. Since the inflation rate has often, in the past, been higher (or much higher) in Turkey than in the USA, he is guessing that purchasing power parity has prevailed – at least to some extent. As members of his team, he has tasked your group with checking this out.

In other words, you have to prepare a report on the following question: Does purchasing power parity typically hold for the Turkish lira-U.S. dollar exchange rate?

As a first pass, Mr. Guessright would like you to do the following:

a. Using monthly data (the highest frequency at which inflation information is available from public sources), please plot the Turkish lira-U.S. dollar exchange rate percent changes against the inflation-rate differential between Turkey and the U.S. (Jan. 1991 – Nov. 2014).

Hint 1: This plot should provide a hint as to whether there are one or more “structural breaks” in the
FX and inflation time series (i.e., times before and after which you see clearly different levels of inflation or patterns of FX rate changes). Such a structural break may help provide a clue as to whether PPP holds during the entire time period, or only during some time sub-period(s) but not during some other time sub-period(s).

Hint 2: Comment on “outliers” in the monthly (or quarterly) observations and any possible “structural breaks” in the observed trends.

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b. Regress percentage exchange rate changes on the inflation differential and provide estimates of the intercept and of the slope coefficient. Interpret the regression results.

Hint 1: before regressing, run a simple correlation analysis – is the correlation high? Is it positive?

Hint 2: if the graph in part a. suggests structural breaks, does it make sense to run the regressions for
the entire sample – or would it make more sense instead to run regressions for sub-periods?

c. Even if PPP did not hold perfectly every month since 1991, it is still possible that inflation differentials nevertheless drove the bulk of nominal exchange rate changes over time. The way to check is to see if the real exchange rate (RER) went up or down substantially for long periods of time.

Using Jan. 1991 and Jan. 2002 as alternative reference months, plot the RER (Turkish Lira vs. USD) (i) since 1991, (ii) in 1991-2001 and (iii) in 2002-2014. Discuss!

d. Compare the respective explanatory powers of PPP vs. uncovered IRP in the 1991-2001 and 2002-2014 sub-periods. Have PPP and/or UIRP held at different horizons (say, 1 month, 3 months, 6 months, 1 year, or even 2-3 years)?

Hint: Several interest-rate series are provided – which would be most relevant to UIRP computations?

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