Determining long-run behavior of dollar-peso exchange rates with the consideration of Philippine financial market performance through time series and risk management analyses

This research investigates how financial markets in the Philippines and the U.S. interact and behave given dynamic changes in market scenarios across time, with an analytical focus of whether investors should hold-on to more U.S. dollars or Philippine peso. The analyses make use of financial management concepts and theories, particularly risk management concepts (with primary focus on foreign exchange risk, inflation risk, demand risk, and political risk), efficient market hypothesis (EMH), and international parity condition, for explaining causal links among specified market indices. As an initial step, this research gathers sub-annual (monthly) data for dollar-peso exchange rates, consumer price index, and selected domestic interest rates from economic and financial learning center (EFLC) in Bangko Sentral ng Pilipinas (BSP). After collecting data, this research analyzes monthly dollar-peso exchange rate trends beginning form January 1994, until December 2013, and selects the best econometric technique for generating optimal ex-ante (2014) monthly forecasts for dollar-peso exchange rates, including methods for multivariate modeling such as the vector auto regression (VAR) and vector error correction model (VECM, if at least one relevant cointegration is present). The methodology applies these state-of-art forecasting methodologies, particularly the favored autoregressive integrated moving average (ARIMA) and time series decomposition methodologies, to generate optimal forecasts as well as generate meaningful analysis, respectively, including the extraction of inferences arising from financial crises in influencing movements of dollar-peso exchange rates. This research hypothesizes that overall financial market outlook in both countries significantly influences dollar-peso exchange rate trends. Prior to estimation, several statistical procedures have been employed for evaluating each of the time series models specified for forecasting 2014 monthly dollar-peso exchange rates. After passing through a series of tests, all estimated models exhibit stationary error terms in the long-run-where long-run refers to a state where financial markets dynamically interact within a financial system. The Johansen cointegration test suggests two cointegrating relationships out of 15 possible two-variable combinations through the maximum Eigenvalue statistic and the trace statistic, but dollar-peso exchange rates do not exist within the system of financial performance indicators-- thus indicating a possible semi-strong form EMH generalized by cointegration test results. After evaluation, the ARIMA model, with a Theil\u27s U statistic of 0.8978, outperforms other specified models. The high, but favorable (having a value of less than 100 percent), Theil\u27s U statistic of 89.78 percent come from the randomness of the dollar-peso exchange rate trend from January 1994 to December 2013. The ARIMA forecasting approach suggests declining dollar-peso exchange rates-- denominated in Philippine peso-- or, in other words, an appreciating Philippine peso for the year 2014. In the context of evaluating overall financial market outlook, dollar-peso exchange rates serve as an outstanding proxy for evaluating overall financial market performance. Investors today can rely on an optimistic perspective in viewing peso movements relative to that of the U.S. dollar, since USD/PHP exchange rates are expected to (and actually) declining, suggesting a stronger peso. Therefore, empirical evaluation of past trends suggests a strengthening peso, which investors can actually account for in their daily decision making. For maintaining a positive financial market outlook, the analysis favors BSP maintaining and keeping inflation at stable levels to sustain the profitability of individual firms (with emphasis on affecting the profitability and leverage ratios in the balance sheet), and suggests firms to keep additional financial reserves to protect their business against dollar depreciation