Aston Emerging Markets Fund (AEMF) is a UK based investment fund specialising in emerging markets. You have recently started your new job at AMEF as one of their research assistants. Your boss, Alan Davies, thinks that it is inevitable that Turkey will soon join the European Union. If this happens, stock prices in Turkey will boom. Hence, he believes that it makes sense to invest in the Turkish stock market. However, Mr Davies is also concerned about the volatility of the exchange rate of the Turkish lira. Hence, he would like to understand what drives this volatility. He thinks that Purchasing Power Parity (PPP) may be holding at least to some extent as inflation rates in Turkey are much higher than in the UK. You have been asked to test whether this proposition is valid. Your task consists of preparing a report to answer the following question. Does PPP hold for the Turkish lira-pound sterling exchange rate?
1.Perform a critical review of the empirical literature on PPP with particular emphasis on emerging markets. Your review should make up approximately one third of your report and show evidence of substantial personal research. The remainder of the report should focus on the following two points.
- Plot the past annual percentage changes in the exchange rate between the UK pound and the Turkish Lira against the annual differential in the inflation rates in UK and Turkey from the early 1970s to the latest year available. Comment on the plot: are there any significant deviations from PPP? You should also use graphs similar to those on slide 19 (page 10), and slide 27 (page 14) for PPP (Topic 3: Parity Relations) to depict any significant deviations from PPP during your period of study. You may use several rather than just one such graph to distinguish between time-periods marked by different economic and/or political events. However, this is entirely up to you. Consult newspaper archives available from the Library (such as Nexis and Newsbank), or online, to determine the possible reasons for these misalignments.
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- Regress the percentage changes in the exchange rate on the inflation rate differential over the period examined. Estimate the intercept and the slope coefficients. Interpret your regression results and focus on answering the question of whether you think that there is a statistically significant relation between changes in the exchange rate and the inflation rate differential. You may want to increase the frequency of your data from annual to monthly for the regression analysis. You should also consider whether it makes sense to re-run your regressions for particular sub-periods. However, if you do so it is important to justify your choice of sub-periods based on what you have learnt from part 2 above.
