Showing papers on "Foreign exchange market published in 1999"

One Money, One Market: Estimating the Effect of Common Currencies on Trade

Abstract: A gravity model is used to asses the separate effects of exchange rate volatility and currency unions on international trade. The panel data set I use includes bilateral observations for five years spanning 1970 through 1990 for 186 countries. In this data set, there are over one hundred pairings and three hundred observations, in which both countries use the same currency. I find a large positive effect of a currency union on international trade, and a small negaitve effect of exchange rate volatility, even after controlling for a host of features, including the endogenous nature of the exchange rate regime. These effects are statistically significant and imply that two countries that share the same currency trade three times as much as theoy would with different currencies. EMU may thus lead to a large increase in internationel trade, with all that entails.

Financial Market Contagion in the Asian Crisis

Abstract: This paper tests for evidence of contagion between the financial markets of Thailand, Malaysia, Indonesia, Korea, and the Philippines. We find that correlations in currency and sovereign spreads increase significantly during the crisis period, whereas the equity market correlations offer mixed evidence. We construct a set of dummy variables using daily news to capture the impact of own-country and cross-border news on the markets. We show that after controlling for own-country news and other fundamentals, there is evidence of cross-border contagion in the currency and equity markets. Copyright 1999, International Monetary Fund

Hedging and liquidation under transaction costs in currency markets

Abstract: We consider a general semimartingale model of a currency market with transaction costs and give a description of the initial endowments which allow to hedge a contingent claim in various currencies by a self-financing portfolio. As an application we obtain a result on the structure of optimal strategies for the problem of maximizing expected utility from terminal wealth.

New Facts in Finance

Abstract: The last 15 years have seen a revolution in the way financial economists understand the world around us. We once thought that stock and bond returns were essentially unpredictable. Now we recognize that stock and bond returns have a substantial predictable component at long horizons. We once thought the capital asset pricing model (CAPM) provided a good description of why average returns on some stocks, portfolios, funds or strategies were higher than others. Now we recognize that the average returns of many investment opportunities cannot be explained by the CAPM, and multifactor models' have supplanted the CAPM to explain them. We once thought that long-term interest rates reflected expectations of future short term rates and that interest rate differentials across countries reflected expectations of exchange-rate depreciation. Now, we see time-varying risk premia in bond and foreign exchange markets as well as in stock markets. Once, we thought that mutual fund average returns were well explained by the CAPM. Now, we recognize ``value'' and other high return strategies in funds, and slight persistence in fund performance. In this article, I survey these new facts. I show how they are related. Each case uses price variables to infer market expectations of future returns; each case notices that an offsetting adjustment (to dividends, interest rates, or exchange rates) seems to be absent or sluggish. Each case suggests that financial markets offer rewards in the form of average returns for holding risks related to recessions and financial distress, in addition to the risks represented by overall market movements.

Exchange Rates and Financial Fragility

Abstract: In this paper we analyze three views of the relationship between the exchange rate and financial fragility: (1) the moral hazard hypothesis, according to which pegged exchange rates offer implicit insurance against exchange risk and thereby encourage reckless borrowing and lending; (2) the original sin hypothesis, which emphasizes an incompleteness in financial markets which prevents the domestic currency from being used to borrow abroad or to borrow long term even domestically; and (3) the commitment problem hypothesis, which sees financial crises as resulting from neither moral hazard nor original sin but from the weakness of the institutions that address commitment problems. We examine the evidence on these hypotheses and draw out their implications for exchange-rate policy in emerging markets.

The institutional foundations of China's market transition

Abstract: April 1999 This paper intends to properly account for China's two decades of market transition by examining its institutional foundations. The journey of transition is analyzed as a two-stage process. In the first stage (1978-93), the system was reformed to unleash the standard forces of incentives, hard budget constraints, and competition, but the underlying institutional forms and mechanisms are far from conventional: reforming government through regional decentralization; entry and expansion of nonstate (mostly local government) enterprises; financial stability through "financial dualism;" and a dual-track approach to market liberalization. In the second stage, China aimed to build a rule-based market system incorporating international best practice institutions but proceeded in its own way. Major progress was made in the first five years (1994-98) on the unification of exchange rates and convertability of the current account; the overhaul of the tax and fiscal systems; reorganization of the central bank; downsizing of the government bureaucracy; and privatization and restructuring of state-owned enterprises. To complete its transition to markets, China still faces serious challenges, especially in transforming its financial system and state-owned enterprises and in establishing the rule of law. The paper concludes by reflecting on the economics of reform and institutional change from the Chinese experience. The main lesson learned is that considerable growth is possible with sensible but not perfect institutions, and that some unconventional "transitional institutions" can be more effective than the best practice institutions for a period of time because of the second-best principle. Specific lessons include: incentives, hard budget constraints, and competition should apply not only to firms but also to governments; reforms can be implemented without creating many or big losers; and successful reforms require appropriate, but not necessarily optimal, sequencing.

Self-Protection for Emerging Market Economies

Abstract: International economic crises will continue to occur in the future as they have for centuries past. The rapid spread of the 1997 crisis in Asia and of the 1982 crisis in Latin America showed how shifts in market perceptions can suddenly bring trouble to countries even when there has been no change in objective conditions. More recently, the sharp jump in emerging market interest rates after Russia's August 1998 default underlined the vulnerability of all emerging market economies to increases in investors' aversion to risk. Emerging market countries that want to avoid the devastating effects of such crises must protect themselves. They cannot depend on the International Monetary Fund or other international organizations nor expect that a new global financial architecture' will make the world economy less dangerous. Taking steps to protect themselves requires more than avoiding those bad policies that make a currency crisis inevitable. The process of contagion makes even the virtuous vulnerable to currency runs. Liquidity is the key to self-protection. A country that has substantial international liquidity -- large foreign exchange reserves and a ready source of foreign currency loans -- is less likely to be the object of a currency attack. Substantial liquidity also permits a country that is attacked from within or without to defend itself better and to make more orderly adjustments. The challenge is to find ways to increase liquidity at reasonable cost.

FX Spreads and Dealer Competition Across the 24-Hour Trading Day

Abstract: This study examines the impact of competition on bid-ask spreads in the spot foreign exchange market. We measure competition primarily by the number of dealers active in the market and find that bid-ask spreads decrease with an increase in competition, even after controlling for the effects of volatility. The expected level of competition is time varying, highly predictable, and displays a strong seasonal component that in part is induced by geographic concentration of business activity over the 24-hour trading day. Our estimates show that the expected addition of one more competing dealer lowers the average quoted spread by 1.7%. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Domestic Political Institutions and Exchange Rate Commitments in the Developing World

Abstract: Policymakers use a fixed exchange rate regime to signal their commitment to low inflation and to exchange rate stability. Increasing economic integration and the rise of democratic institutions make it more difficult for policymakers to maintain the credibility of this commitment. We use binary probit (with a variety of corrections for autocorrelated and heteroscedastic disturbances) to test hypotheses relating democratic institutions to exchange rate regime choice on a sample of 76 developing countries over the period 1973‐1994. The empirical analysis indicates that domestic political preferences—as measured by the structure of domestic political institutions and the fractionalization of the party system—influence exchange rate regime choice. We find that floating exchange rate regimes are more likely in democratic than in nondemocratic polities and that democratic polities with majoritarian electoral systems are more likely to fix their exchange rates than those with systems of proportional representation. The growth of international capital markets is truly extraordinary. Cross-border capital flows dwarf those of international trade: recent estimates suggest that foreign exchange trading alone now exceeds one trillion dollars a day. The magnitude and volatile nature of international capital flows has led some political economists to suggest that increased economic integration and capital mobility has become so pervasive that it now acts as a “structural characteristic of the international system, similar to anarchy” (Keohane and Milner, 1996:257). These scholars point to globalization as a crucial factor leading to a convergence of economic policy in the industrialized world. While a wave of economic liberalization has swept OECD economies, governments in developing countries still use a variety of traditional economic tools to protect the relative autonomy of their domestic policies. Vital in this process is exchange rate policy for it is the exchange rate that serves as a buffer between international and domestic markets. Even after the collapse of the Bretton Woods system of pegged exchange rates, most developing countries continue to fix the value of their currency to that of their major trading partner. The logic is clear: by fixing the domestic currency’s value to that of a trading partner, exchange rate volatility is minimized. As a result, bilateral flows of capital and goods are not disrupted by exchange rate uncertainty and

'Once-in-a-Generation' Yen Volatility in 1998: Fundamentals, Intervention, and Order Flow

Abstract: The yen provided foreign exchange market participants with 'once-in-a-generation' volatility movements in 1998. For instance, after many months of uneven yen depreciation a remarkable period of yen appreciation was experienced where, in one two-day period, the U.S. dollar dropped in value by 20 yen, market-makers were refusing to quote yen/dollar prices for more than $1 million, and funds with short yen positions incurred massive losses. Not since the early 1970s has the yen-dollar exchange rate experienced such shifts. Analysts claimed that the yen reversal was due to order flow driven by changing tastes for risk and hedge-fund herding on unwinding yen 'carry trade' positions rather than any fundamentals related to the yen. In this paper, we examine the high-frequency evidence on the yen/dollar exchange rate in 1998 and provide a detailed characterization of the return volatility. Evidence of shifting fundamentals is provided by a comprehensive list of macroeconomic announcements from both the U.S. and Japan. While macroeconomic announcements and intervention are found to have significant effects on volatility, our results lead to the conclusion that order flow played a more important role than news regarding fundamentals. Evidence regarding the independent effect of order flow was provided by spot, forward, and futures positions of major market participants. These position changes are found to be significant determinants of volatility. Since such portfolio shifts are revealed to the market through trading, the results are consistent with order flow playing a significant role in the revelation of private information and the associated exchange rate shifts.

Exchange Rate Effects of Central Bank Interventions: An Analysis of Transaction Prices

Abstract: The impact of sterilised interventions by the Swiss National Bank on the Swiss franc/U.S. dollar exchange rate is examined for the 1986-94 period. The paper extends results from earlier studies by using the actual prices of interventions. Based on the fact that all Swiss National Bank interventions are announced, our test exploits the informational differences between interventions and customer transactions. A key finding is that only initial interventions matter; customer transactions and subsequent interventions have no influence. When the Bretton Woods system of fixed exchange rates broke up in the early 1970s, central banks continued to intervene on the foreign exchange market. In the meantime, a substantial literature has emerged that focuses on the effectiveness of official interventions. This literature has been summarised by Edison (1993) and Almekinders (1995, chapter 3). Its central policy issue is whether sterilised interventions, defined as interventions that leave the monetary base unchanged, can have a significant influence on exchange rate behaviour. Macroeconomic theory proposes various channels for interventions to operate through. But the empirical evidence accumulated over the years is less encouraging. It suggests that there is no permanent effect of (sterilised) interventions on the exchange rate. More surprisingly perhaps, even shortterm effects are hard to pin down. The evidence is weak and sample dependent at best. In most cases, coefficients are either insignificant or have the wrong sign; see Almekinders (1995, chapter 6), Baillie and Humpage (1992), Dominguez (1998), Dominguez and Frankel (1993), Klein and Rosengren (1991), Lindberg (1994), and Osterberg and Wetmore Humes (1995). During the last decade, the bulk of the empirical research has concentrated on the analysis of daily or weekly data. This line of research, which adopts the view that exchange rate markets are highly efficient, was stimulated by the decision of the Federal Reserve Board and the Deutsche Bundesbank to make their daily intervention data available to outside researchers. To rationalise the gap between the fragile empirical evidence and the manifest interest paid by the media and other observers to interventions, various explanations have been offered. In this paper, we stress two measurement problems. First, there is the problem of properly defining the exchange rate change in the regression analysis. Since intervention exchange rates are not available, the

Exchange Rate Arrangements and Currency Convertibility : Developments and Issues

Abstract: This study reviews developments and issues in the exchange arrangements and currency convertibility of IMF members. Completed in 1997, the report outlines the developments on the basis of information available at that time. The principle information source is the Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) prepared in consultation with national authorities.

Trading volumes and transaction costs in the foreign exchange market: Evidence from daily dollar–yen spot data

Abstract: A Generalized Method of Moments estimation of the determinants of dollar/yen bid–ask spreads is undertaken. In particular, a long time-series of daily spot foreign exchange trading volumes is used for the first time. In line with standard spread models and volume theories, it can be shown that unpredictable foreign exchange turnover (a measure of the rate of information arrival) increases spreads, while predictable turnover decreases them. Both effects are strongly significant when employing spot turnover instead of proxies like forward turnover as in previous studies. The results are also found to be robust when unpredictable Reuters quoting frequency is used as an instrument for unpredictable trading volumes to cope with their endogeneity. Spread estimations with plain (non-decomposed) volumes are rejected as misspecified. Finally, there is evidence for the conditional heteroscedasticity of unpredictable spot foreign exchange volumes.

Proposed strategy for a regional exchange rate arrangement in post-crisis East Asia

Abstract: After discussing major conceptual, and empirical issues relevant to the exchange rate policies of East Asian countries, the authors propose a regional exchange rate arrangement designed to promote intra-regional exchange rate stability, and regional economic growth. They argue that: 1) For developing countries, exchange rate volatility tends to significantly hurt trade and investment, making it inadvisable to adopt a system of freely floating exchange rates. 2) Given the high share of intra-regional trade, and the similarity of trade composition in East Asia, exchange rate policy should be directed toward maintaining intra-regional exchange rate stability, to promote trade, investment, and economic growth. 3) the current policy of maintaining exchange rate stability against U.S. dollar as an informal, uncoordinated mechanisms for ensuring intra-regional exchange rate stability is sub-optimal. A pragmatic policy option - conducive to a more robust framework for cooperation in monetary, and exchange rate policy - wold be a coordinated action to shift the target of nominal exchange rate stability, to a basket of tri-polar currencies (the U.S. dollar, the Japanese yen, and the Euro). This alternative would better reflect the region's diverse structure of trade, and foreign direct investment. The authors envision no rigid peg. Instead, at least initially, each country could choose its own formal exchange rate arrangement - be it currency board, a crawling peg, or a basket peg with wide margins. At times of crisis, the peg might be temporarily suspended, subject to the rule that the exchange rate would be restored to the original level as soon as practical. Only in extreme circumstances, would the level be adjusted to reflect new equilibrium conditions.

Is Intervention a Signal of Future Monetary Policy? Evidence from the Federal Funds Futures Market

Abstract: Sterilized foreign exchange market intervelltioll may affect the exchange rate if it signals future monetary policy actions. Sigllaling will be effective if the celltral bank backs up interventioll with predictable changes in the stance of molletary policy and, in turn, affects currellt expectations. We investigate whether illtervention operations in the United States are lelated to changes in expectatiolls over the stance of future monetary policy, whele expectations are proxied by ifederal funds futures rates. This relatively new futures market instrument has proved to be all efficiellt and ullbiased predictor of the future spot federal funds rate. Estimates obtained from a GARCH time-series model over the l 989-93 period using daily data do not suppol1 the signalillg hypothesis: dollar-suppolt intervention is not related to a rise in expected future short-term interest ates (monetary tightening). However, intervention appears to significantly increase the conditional variance of federal funds futures rates, suggesting that it adds considerable noise to the market alld possibly increasing the degree of uncertainty ovet the future course of molletary policy. THE EFFECT OF FOREIGN EXCHANGE MARKET INTERVENTION on exchange rates is a subject of continuing controversy. Few doubt that unsterilized intervention may affect nominal exchange rates by changing interest rates and monetary aggregates. However, the effect of sterilized intervention on exchange rates is less clear. The "portfolio balance" channel, through which sterilized intervention changes the currency denomination of relative asset supplies and thereby the exchange risk premium if assets are imperfect substitutes, has received little empirical support (for example, Rogoff 1984; Humpage 1991; Edison 1993; Sweelaey 1995,

Price, exchange rate volatility and Nigeria's agricultural trade flows: a dynamic analysis

Abstract: One of the most dramatic events in Nigeria over the past decade was the devaluation of the Nigerian naira with the adoption of a structural adjustment programme (SAP) in 1986. A cardinal objective of the SAP was the restructuring of the production base of the economy with a positive bias for the production of agricultural exports. The foreign exchange reforms that facilitated a cumulative depreciation of the effective exchange rate were expected to increase the domestic prices of agricultural exports and therefore boost domestic production.

Liquidity Crises in Emerging Markets: Theory and Policy

Abstract: We build a model of financial sector illiquidity in an open economy. Illiquidity defined as a situation in which a country's consolidated financial system has potential short-term obligations in foreign currency that exceed the amount of foreign currency it can have access to on short notice can be associated with self fulfilling bank and/or currency crises. We focus on the policy implications of the model, and study the role of capital inflows and the maturity of external debt, the way in which real exchange rate depreciation can transmit and magnify the effects of bank illiquidity, options for financial regulation, the role of debt and deficits, and the implications of adopting different exchange rate regimes.

Cross-border trade and the parallel currency market - trade and finance in the context of structural adjustment : a case study from Kano, Nigeria

Abstract: A "new regionalism" is gathering pace in West Africa, underpinned by the growing activities of informal cross-border traders. The authors of this study challenge the assumptions of the World Bank t ...

An Intraday Analysis of the Effectiveness of Foreign Exchange Intervention

Abstract: Les auteurs cherchent a etablir si les interventions officielles du Canada sur le marche des changes reussissent a moderer la volatilite intrajournaliere du taux de change du dollar canadien par rapport a la devise americaine. Pour etudier cette question, ils font appel aux cours cotes par le dollar toutes les dix minutes sur une periode […]

Spreads, Information Flows and Transparency Across Trading Systems Federal Reserve Bank of Chicago, Issues in Financial Regulation

Abstract: This paper analyzes the dynamics of price formation for a strictly identical derivatives contract which is traded simultaneously at two competing exchanges. The domestic exchange is situated in the country that issues the underlying instrument. The foreign exchange offers a large international capital centre with many diversificationpossibilities. In addition, the exchanges are characterized by different trading systems. The domestic exchange operates by automated trading, the foreign exchange uses open outcry with an automated late afternoon session. We will investigate whether these differences support the trading system segmentation hypothesis. Our working hypothesis is two-fold. First, we investigate whether the transparency of each trading system affects quote setting. Second, we analyze whether the relative transparency of each market influences the lead/lag relationship between the two markets. Both hypotheses are empirically tested for the Bund futures contract as it is traded in London (LIFFE) and Frankfurt (DTB).

Noise Trading and Exchange Rate Regimes

Abstract: Both the literature and new empirical evidence show that exchange rate regimes differ primarily by the noisiness of the exchange rate, not be measurable macroeconomic fundamentals. This motivates a theoretical analysis of exchange rate regimes with noise traders. The presence of noise traders can lead to multiple equilibria in the foreign exchange market. The entry of noise traders both create and share the risk associated with exchange rate volatility. In such circumstances, monetary policy can be used to lower exchange rate volatility without altering macroeconomic fundamentals.

Macroeconomic Implications of the Beliefs and Behavior of Foreign Exchange Traders

Abstract: We report findings from a survey of United States foreign exchange traders. Our results indicate that (i) technical trading best characterizes about 30% of traders, with this proportion rising from five years ago; (ii) news about macroeconomic variables is rapidly incorporated into exchange rates; (iii) the importance of individual macroeconomic variables shifts over time, although interest rates always appear to be important, and; (iv) economic fundamentals are perceived to be more important at longer horizons. The short run deviations of exchange rates from their fundamentals are attributed to excess speculation and institutional customer/hedge fund manipulation. Speculation is generally viewed positively, as enhancing market efficiency and liquidity, even though it exacerbates volatility. Central bank intervention does not appear to have a substantial effect, although there is general agreement that it increases volatility. Finally, traders do not view purchasing power parity as a useful concept, even though a significant proportion (40%) believe that it affects exchange rates at horizons of over six months.

Adjustment and Liberalization in Kenya: The Financial and Foreign Exchange Markets

Abstract: The paper analyses the impact of liberalization on two key and interrelated markets in Kenya, the financial and the foreign exchange markets. It is shown that the inflation profile changes with exchange rate policy, interest rates have not been market determined even after liberalization, interest rate spreads have increased with liberalization, a reflection of inefficiency in the financial market, while foreign and domestic interest rate differential and short-term speculative capital inflows affect the real exchange rate. The policy conflict of targeting a competitive exchange rate and low inflation with interest rate as the only instrument is shown to lead to a policy dilemma and to complicate macroeconomic management in the 1990s in an environment where fiscal adjustment has not taken place. Copyright © 1999 John Wiley & Sons, Ltd.

Measuring Exchange Market Pressure and Central Bank Intervention

Abstract: This study contributes to the measurement of exchange market pressure and central bank intervention policy in a system of floating currency and partly sterilized foreign exchange interventions. A model-consistent approach is used. The measures of exchange market pressure and degree of intervention in the foreign exchange market are derived in the context of an empirically oriented small open economy monetary model with rational expectations. Monetary and foreign exchange policies are explicitly defined and foreign exchange interventions are allowed to be partly sterilized. Finally, the model is applied to Finnish data in order to analyse the pressure on the markka, which was floating during the period 1992?1996, and the Bank of Finland's reaction to that pressure. In contrast to most other empirical studies using various proxy variables, actual intervention data is used. According to the estimation results, the inclusion of the monetary policy reaction function and especially the sterilization of foreign exchange intervention makes the values of the measures of exchange market pressure and intervention policy more realistic and hence easier to interpret. This means that the fact that foreign exchange interventions are at least partly sterilized in the main industrial countries should be taken into account when exchange market pressure and central bank intervention policy are measured. This has not been done in other studies using a model-consistent approach. When the Bank of Finland's reaction to exchange market pressure is analysed, the results seem to suggest that the Bank let the markka float quite freely, reduced its intervention activity gradually as exchange market pressure diminished, and considered markka appreciation more desirable than depreciation during the markka float.

Foreign exchange market as a lattice gauge theory

Abstract: A simple model of the foreign exchange market is exactly a lattice gauge theory. Exchange rates are the exponentials of gauge potentials defined on spatial links while interest rates are related to gauge potentials on temporal links. Arbitrage opportunities are given by nonzero values of the gauge-invariant field tensor or curvature defined on closed loops. Arbitrage opportunities involving cross-rates at one time are “magnetic fields,” while arbitrage opportunities involving future contracts are “electric fields.”