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We build currency portfolios based on the paradigm that exchange rates slowly converge to their equilibrium to highlight three results. First, this property can be exploited to build profitable portfolios. Second, the slow pace of convergence at short-horizons is consistent with the evidence of profitable carry trade strategies, i.e. the common practice of borrowing in low-yield currencies and investing in high-yield currencies. Third, the predictive power of equilibrium exchange rates may boost the performance of carry trade strategies.

This thesis is concerned with the origins of exchange rate instability and the scope for economic reform. Several aspects of recent macroeconomic instability in Russia are discussed which, we argue, reveal the origins of this problem.\ud \ud The first chapter combines currency substitution and price stickiness. It aims to account for the weakness of the real exchange rate and the net accumulation of foreign exchange, that so frequently characterise unstable economies. The essence of the discussion is that, when faced with severe tight controls on capital, agents are able to substitute foreign currency for local currency via the current account. The model has a simple dynamic structure, similar to the Dornbusch model.\ud \ud The second chapter uses the Cohen and Michel procedure to extend the time inconsistency approach to an open economy, a-la-Dornbusch framework. A special loss function is used, but the same methodology may be applied to address other economic issues. When time consistency is assumed, future loose monetary policies are foreseen and hence have current consequences. We argue that the more the government has an inflationary instinct, the greater the experience of undervaluation and the fall in liquidity.\ud \ud The third chapter builds on the work of the second. It is argued that even in this open economy. a-la-Dornbusch framework, the standard result holds: credibility is enhanced by delegating monetary policy to a conservative central banker. The economic consequences of this are twofold: a smaller real exchange rate undervaluation and a reduced fall in liquidity. In addition, we propose an extension of this analysis by letting currency substitution, between domestic and foreign assets, be the alternative assumption to perfect capital mobility. The assumption of currency substitution leaves largely unchanged the dynamic structure of the analysis, but gives rise to a quite different economic interpretation.\ud \ud The fourth chapter describes the reasons why policy makers decide on restrictive foreign exchange policies. A currency substitution framework is used to highlight the consequences of foreign exchange leakages between official and black markets. The model is solved by applying the technique suggested by Dixit and Currie to determine the free variable as a function of the predetermined variables of the system\ud \ud A fifth chapter attempts to pull together the main arguments, and conclusions arising from these, which have been discussed throughout the thesis.