Showing papers on "Foreign exchange market published in 2006"

Exchange Rates, Equity Prices, and Capital Flows

Abstract: We develop an equilibrium model in which exchange rates, stock prices and capital flows are jointly determined under incomplete forex risk trading. Incomplete hedging of forex risk, documented for US global mutual funds, has three important implications: 1) exchange rates are almost as volatile as equity prices when the forex liquidity supply is not infinitely price elastic; 2) higher returns in the home equity market relative to the foreign equity market are associated with a home currency depreciation; 3) net equity flows into the foreign market are positively correlated with a foreign currency appreciation. The model predictions are strongly supported at daily, monthly and quarterly frequencies for 17 OECD countries vis-a-vis the US. Moreover, correlations are strongest after 1990 and for countries with higher market capitalization relative to GDP, suggesting that the observed exchange rate dynamics are indeed related to equity market development.

Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency

Abstract: Might the dollar eventually follow the precedent of the pound and cede its status as leading international reserve currency? Unlike the last time this question was prominently discussed, ten years ago, there now exists a credible competitor: the euro. This paper econometrically estimates determinants of the shares of major currencies in the reserve holdings of the world’s central banks. Significant factors include: size of the home country, inflation rate (or lagged depreciation trend), exchange rate variability, and size of the relevant home financial center (as measured by the turnover in its foreign exchange market). We have not found that net international debt position is an important determinant. Network externality theories would predict a tipping phenomenon. Indeed we find that the relationship between currency shares and their determinants is nonlinear (which we try to capture with a logistic function, or else with a dummy “leader” variable for the largest country). But changes are felt only with a long lag (we estimate a weight on the preceding year’s currency share around 0.9). The advent of the euro interrupts the continuity of the historical data set. So we estimate parameters on pre-1999 data, and then use them to forecast the EMU era. The equation correctly predicts a (small) narrowing in the gap between the dollar and euro over the period 1999-2004. Whether the euro might in the future rival or surpass the dollar as the world’s leading international reserve currency appears to depend on two things: (1) do enough other EU members join euroland so that it becomes larger than the US economy, and (2) does US macroeconomic policy eventually undermine confidence in the value of the dollar, in the form of inflation and depreciation. What we learn about functional form and parameter values helps us forecast, contingent on these two developments, how quickly the euro might rise to challenge the dollar. Under two important scenarios – the remaining EU members, including the UK, join EMU by 2020 or else the recent depreciation trend of the dollar persists into the future – the euro may surpass the dollar as leading international reserve currency by 2022.

Correlation networks among currencies

Abstract: By analyzing the foreign exchange market data of various currencies, we derive a hierarchical taxonomy of currencies constructing minimal-spanning trees. Clustered structure of the currencies and the key currency in each cluster are found. The clusters match nicely with the geographical regions of corresponding countries in the world such as Asia or East Europe, the key currencies are generally given by major economic countries as expected.

The Exchange Rate in a Behavioral Finance Framework

Abstract: This book provides an alternative view of the workings of foreign exchange markets The authors' modeling approach is based on the idea that agents use simple forecasting rules and switch to those rules that have been shown to be the most profitable in the past This selection mechanism is based on trial and error and is probably the best possible strategy in an uncertain world, the authors contend It creates a rich dynamic in the foreign exchange markets and can generate bubbles and crashes Sensitivity to initial conditions is a pervasive force in De Grauwe and Grimaldi's model It explains why large exchange-rate changes and volatility clustering occur It also has important implications for understanding how the news affects the exchange rate De Grauwe and Grimaldi conclude that news in fundamentals has an unpredictable effect on the exchange rate Sometimes, they maintain, it alters the exchange rate considerably; at other times it has no effectwhatsoever The authors also use their model to analyze the effects of official interventions in the foreign exchange market They show that simple intervention rules of the "leaning-against-the-wind" variety can be effective in eliminating bubbles and crashes in the exchange rate They further demonstrate how, quite paradoxically, by intervening in the foreign exchange market the central bank makes the market look more efficient Clear and comprehensive, The Exchange Rate in a Behavioral Finance Framework is a must-have for analysts in foreign exchange markets as well as students of international finance and economics

Technical Trading-Rule Profitability, Data Snooping, and Reality Check: Evidence from the Foreign Exchange Market

Abstract: We report evidence on the profitability and statistical significance among 2,127 technical trading rules. The best rules are found to be significantly profitable based on standard tests. We then employ White’s (2000) Reality Check to evaluate these rules and find that data-snooping biases do not change the basic conclusions for the full sample. A sub-sample analysis indicates that the data-snooping problem is more serious in the second half of the sample. Profitability becomes much weaker in the more recent period, suggesting that the foreign exchange market becomes more efficient over time. Evidence from cross exchange rates confirms the basic findings.

New Rates from New Weights

Abstract: This paper describes the result and the methodology of updating the IMF's nominal and real effective exchange rate weights on the basis of trade data over 1999-2001. The underlying framework is an updated version of the IMF's current effective exchange rate calculation, which uses weights largely based on 1989-1991 data. Since then, substantial changes have occurred in international trade relations, warranting a recalculation of effective exchange rate indices on the basis of new trade patterns. Updated weights show that the United States and developing countries (most notably China) have grown in their importance in global trade, while Japan and the European Union have declined, with substantial implications for the path of the dollar and exchange rate effects of emerging market crises since 1995.

Foreign exchange reserve accumulation in emerging market economies: what are the domestic implications?

Abstract: This paper discusses some of the domestic implications of the recent large-scale use of foreign exchange intervention by emerging market economies to resist currency appreciation. Over the past five years, many countries have adopted an accommodating monetary policy while intervening. Despite the prolonged period of low interest rates that resulted, various other forces have kept inflation under control and so eased one policy dilemma for central banks. Nevertheless, large and prolonged reserve accumulation can still create risks other than near-term inflation. These include: high intervention costs; monetary imbalances; overheated credit and asset markets; and very liquid and perhaps distorted banking systems.

Under the microscope: the structure of the foreign exchange market

Abstract: We provide a detailed, up-to-date description of the microstructure of the foreign exchange market and of the behaviour of participant groups. In the light of this, we highlight shortcomings in existing theoretical models of market interaction and present an outline alternative model that marries theoretical prediction and current market practice. Copyright © 2006 John Wiley & Sons, Ltd.

Support for Resistance: Technical Analysis and Intraday Exchange Rates

Abstract: "Support" and "resistance" levels - points at which an exchange rate trend may be interrupted and reversed - are widely used for short-term exchange rate forecasting. Nevertheless, the levels' ability to predict intraday trend interruptions has never been rigorously evaluated. This article undertakes such an analysis, using support and resistance levels provided to customers by six firms active in the foreign exchange market. The author offers strong evidence that the levels help to predict intraday trend interruptions. However, the levels' predictive power is found to vary across the exchange rates and firms examined.

Foreign Equity Trading and Emerging Market Volatility: Evidence from Indonesia and Thailand

Abstract: This paper documents a strong contemporaneous relationship between foreign equity trading and market volatility in Indonesia and Thailand. Although foreign selling accounts for only a small portion of daily trading, it has the highest explanatory power for market volatility in both countries. Trading within foreign and local investor groups is often negatively related to volatility. The findings are robust to different sub-periods and different measures for volatility and trading activities. We explore two economic explanations for the asymmetric effects of foreign and local investors.

Carry Trades and Speculative Dynamics

Abstract: When a currency trader borrows Japanese yen at 1 percent to fund the purchase of US dollar assets that yield 5 percent, the trader makes a profit even if the dollar/yen exchange rate remains unchanged. This paper examines the implications of such carry trades for speculative dynamics. In the absence of carry costs, we establish the benchmark result that speculation can be ruled out. However, carry costs can drastically change the nature of the price dynamics. Our results suggest that markets that combine significant costs of carry and low "resiliency" (such as the foreign exchange market) have the pre-conditions for large and persistent deviations of price from fundamentals, followed by abrupt reversals. Not only does uncovered interest parity fail, but a currency with a high interest rate will exhibit the classic price pattern of going up by the stairs, and coming down in the elevator.

Foreign exchange interventions under inflation targeting: the czech experience

Abstract: I. INTRODUCTION This article discusses the role of direct foreign exchange (FX) interventions in the inflation-targeting regime, focusing on the Czech experience since 1998. The Czech experience may contribute as an important case study to the growing international literature on managed floating in combination with the inflation-targeting framework. By interventions, we mean purchases or sales of FX by the Czech National Bank (CNB) intended to influence the exchange rate developments in terms of either the exchange rate level or the exchange rate volatility. The article is organized as follows: After a brief literature overview in section II, the origins of the current Czech monetary policy framework are explained in section III. Section IV describes the exchange rate developments in this regime. Section V presents the major policy steps in the exchange rate management. Section VI reviews some stylized facts on the effectiveness of the interventions and presents its econometric analysis. Section VII discusses the consistency of the interventions with the inflation-targeting regime. Section VIII summarizes and concludes. II. LITERATURE OVERVIEW The ongoing liberalization of capital flows and numerous currency crises during the 1990s have led to a more cautious approach to fixed exchange rates. At the same time, the number of countries with floating exchange rates has increased substantially. Many of those countries that have moved toward exchange rate flexibility have chosen inflation targeting as a new nominal anchor for their economies (see Mahadeva and Sterne, 2000; Truman, 2003). As part of this trend, the number of small open economies that operate the inflation-targeting regime has grown substantially. For these countries, it is a crucial issue what approach should the central bank use to deal with possibly large exchange rate fluctuations. Their economies may be quite vulnerable to exchange rate shocks and may exhibit a "fear of floating" (Calvo and Reinhart, 2000). This raises the question to what extent a central bank pursuing the inflation targeting should try to manage the exchange rate. The theory of inflation targeting (see, e.g., Svensson, 2000) typically assumes that the elasticity of short-term capital flows to yield differentials is infinitely high. There is thus no use trying to influence the supply or demand of FX because all central bank's interventions would be countervailed by private capital flows. As a result, the theory of inflation targeting typically assumes or even recommends a purely floating exchange rate. The only instrument that the central bank then has is its short-term interest rate. To the extent that the exchange rate fluctuations influence the targeted inflation rate and the output gap, interest rates are used to respond to the exchange rate shocks. Nevertheless, some recent literature has started to argue in favor of managing the floating exchange rate as part of the inflation-targeting regime (Bofinger and Wollmershaeuser, 2001; Goldstein, 2002; Truman, 2003). It has been proposed that FX interventions could reduce one major source of shocks that small open economies face, that is, excessive exchange rate volatility, and thus lead to a more favorable trade-off between stable inflation and real economic activity. (1) This would improve the overall performance of the inflation-targeting regime. Some of the inflation-targeting countries do use FX interventions more or less frequently in practice. This group includes Australia, Chile, South Korea, Sweden (in 2001), Hungary, and Slovakia, to name just a few countries from different continents and regions. Most recently, the Reserve Bank of New Zealand, which is a pioneer of the inflation targeting, was given a mandate to use direct FX interventions as a monetary policy instrument under prespecified conditions. (2) There is thus not a general consensus on the "fall of foreign exchange market intervention as a policy tool" (Schwartz, 2000). …

Price discovery in the foreign currency futures and spot market

Abstract: In this paper, we compare price discovery in the foreign exchange futures and spot markets during a period in which the spot market was less transparent but had higher volume than the futures market. We develop a foreign exchange futures order flow measure that is a proxy for the order flow observed by Chicago Mercantile Exchange pit traders. We find that both foreign currency futures and spot order flow contain unique information relevant to exchange rate determination. When we measure contributions to price discovery using the methods of Hasbrouck and of Gonzalo and Granger, we obtain results consistent with our order flow findings. Taken together, our evidence suggests that the amount of information contained in currency futures prices is much greater than one would expect based on relative market size.

Arbitrage in the Foreign Exchange Market: Turning on the Microscope

Abstract: This paper investigates the presence and characteristics of arbitrage opportunities in the foreign exchange market using a unique data set for three major capital and foreign exchange markets that covers a period of more than seven months at tick frequency, obtained from Reuters on special order. We provide evidence on the frequency, size and duration of round-trip and one-way arbitrage opportunities in real time. The analysis unveils the existence of numerous short-lived arbitrage opportunities, whose size is economically significant across exchange rates and comparable across different maturities of the instruments involved in arbitrage. The duration of arbitrage opportunities is, on average, high enough to allow agents to exploit deviations from the law of one price, but low enough to explain why such opportunities have gone undetected in much previous research using data at lower frequency.

The Case for an International Reserve Diversification Standard

Abstract: Rumors about the actual or potential currency diversification of countries' foreign exchange holdings out of dollars are not a new phenomenon. This working paper argues that such concerns about reserve diversification are exaggerated. We present evidence that the extent of actual diversification has been modest to date. Nevertheless, the potential for reserve diversification adds volatility to foreign exchange markets and can catalyze abrupt exchange rate movements. We argue that policymakers acting in their own national interests can do something constructive to reduce the volatility introduced into foreign exchange and financial markets by rumors of large-scale international foreign exchange reserve diversification. We propose the voluntary adoption by major foreign exchange reserve holders in particular of an International Reserve Diversification Standard consisting of two elements: (1) routine disclosure of the currency composition of official foreign exchange holdings and (2) a commitment by each adherent to adjust gradually the actual currency composition of its reserves to any new benchmark for those holdings.

Exchange rate stabilization in developed and underdeveloped capital markets

Abstract: The target zone model by Krugman (1991) assumes that foreign exchange intervention targets exchange rate levels. We argue that the fit of this model depends on the stage of development of capital markets. Foreign exchange intervention of countries with highly developed capital markets is in line with Krugman's (1991) model as the exchange rate level is targeted (mostly to sustain the competitiveness of exports) and the volatility of day-to-day exchange rate changes are left to market forces. In contrast, countries with underdeveloped capital markets control both volatility of day-to-day exchange rate changes as well as long-term fluctuations of the exchange rate levels to sustain the competitiveness of exports as well as to reduce the risk for short-term and long-term payment flows. Estimations of foreign exchange intervention reaction functions for Japan and Croatia trace the asymmetric pattern of foreign exchange intervention in countries with developed and underdeveloped capital markets.

Monetary Policy Challenges in Emerging Markets: Sudden Stop, Liability Dollarization, and Lender of Last Resort

Abstract: The paper argues that Emerging Market economies (EMs) face financial vulnerabilities that weaken the effectiveness of a domestic Lender of Last Resort (LOLR). As a result, monetary policy is inextricably linked to the state of the credit market. In particular, the central bank should be ready to operate as LOLR during Sudden Stop (of capital inflows) by releasing international reserves in an effective manner. These conditions also impact on optimal monetary policy in normal but high-volatility periods. The paper further argues that during those periods interest rate rules may engender excessive volatility of exchange rates and, thus, that it may be advisable to temporarily supplement those rules by foreign exchange market intervention or outright exchange rate pegging. At a fundamental level, the analysis suggests that the state-of-the-art literature summarized by Woodford (2003) or even more heterodox approaches exemplified by Stiglitz and Greenwald (2003) are likely fall short of providing a satisfactory guide for monetary policy in EMs.

Understanding South African financial markets

Abstract: Rudiments of the South African financial system. The South African Reserve Bank. Banks. Microfinance institutions. Regulation of the financial markets. Insurers. Retirement funds. Investment institutions. Risk and return. The money market. The bond market. The share market. The foreign exchange market. Derivatives.

Price discovery in the foreign exchange futures market

Abstract: Examination is made of the relative contributions to price discovery of the floor and electronically traded euro FX and Japanese yen futures markets and the corresponding retail on-line foreign exchange spot markets. GLOBEX electronic futures contracts provide the most price discovery in the euro; the on-line trading spot market provides the most in the Japanese yen. The floor-traded futures markets contribute the least to price discovery in both the euro and the Japanese yen markets. The overall results show that electronic trading platforms facilitate price discovery more efficiently than floor trading. Futures traders may also extract information from on-line spot prices. © 2006 Wiley Periodicals, Inc. Jrl Fut Mark 26:1131–1143, 2006

The Transition to Electronic Communications Networks in the Secondary Treasury Market

Abstract: This article reviews the history of the recent shift to electronic trading in equity, foreign exchange, and fixed-income markets. The authors analyze a new data set: the eSpeed electronic Treasury network. They contrast the market microstructure of the eSpeed trading platform with the traditional voice-assisted networks that report through GovPX. The electronic market (eSpeed) has greater volume, smaller spreads, and a lower estimated trade impact than the voice market (GovPX). ; Appeared earlier as Working Paper 2006-012

The Evolution of Exchange Rate Policy and Capital Controls in Australia

Abstract: After the end of the Bretton Woods system in the early 1970s, exchange rate policy in Australia moved through several regimes over an extended period. The overarching theme was to increase flexibility and efficiency in the Australian currency market and the financial system more generally. This paper documents Australia's gradual move from a fixed to a floating exchange rate and the abolition of capital controls, with an emphasis on the thinking behind various reforms and the practical difficulties encountered during the reform process. Policy reform was often in response to external forces exposing deficiencies in the prevailing system, rather than through a carefully planned path to greater flexibility. Ultimately, a combination of domestic and international factors rendered the move to a flexible exchange rate largely inevitable.

Estimation of a simple agent-based model of financial markets: An application to Australian stock and foreign exchange data

Abstract: Following Alfarano et al. [Estimation of agent-based models: the case of an asymmetric herding model, Comput. Econ. 26 (2005) 19–49; Excess volatility and herding in an artificial financial market: analytical approach and estimation, in: W. Franz, H. Ramser, M. Stadler (Eds.), Funktionsfahigkeit und Stabilitat von Finanzmarkten, Mohr Siebeck, Tubingen, 2005, pp. 241–254], we consider a simple agent-based model of a highly stylized financial market. The model takes Kirman's ant process [A. Kirman, Epidemics of opinion and speculative bubbles in financial markets, in: M.P. Taylor (Ed.), Money and Financial Markets, Blackwell, Cambridge, 1991, pp. 354–368; A. Kirman, Ants, rationality, and recruitment, Q. J. Econ. 108 (1993) 137–156] of mimetic contagion as its starting point, but allows for asymmetry in the attractiveness of both groups. Embedding the contagion process into a standard asset-pricing framework, and identifying the abstract groups of the herding model as chartists and fundamentalist traders, a market with periodic bubbles and bursts is obtained. Taking stock of the availability of a closed-form solution for the stationary distribution of returns for this model, we can estimate its parameters via maximum likelihood. Expanding our earlier work, this paper presents pertinent estimates for the Australian dollar/US dollar exchange rate and the Australian stock market index. As it turns out, our model indicates dominance of fundamentalist behavior in both the stock and foreign exchange market.

The Importance of Corporate Foreign Debt in Managing Exchange Rate Exposures in Non‐Financial Companies

Abstract: This empirical study of the exchange rate exposure management of Danish non-financial firms listed on the Copenhagen Stock Exchange shows that debt denominated in foreign currency (‘foreign debt’) is a very important alternative to the use of currency derivatives. The results show that the relative importance of foreign debt is positively related to (1) the extent of foreign subsidiaries, (2) the relative value of assets in place, and (3) the debt ratio. The pivotal role of time horizon is emphasised. These findings are important to firms in other countries with open economies.