Showing papers on "Foreign exchange market published in 2012"

Beyond the Carry Trade: Optimal Currency Portfolios

Abstract: We test the relevance of technical and fundamental variables in forming currency portfolios. Carry, momentum and reversal all contribute to portfolio performance, whereas the real exchange rate and the current account do not. The resulting optimal portfolio outperforms the carry trade and other naive benchmarks in an extensive 16 year out-of-sample test. Its returns are not explained by risk and are valuable to diversified investors holding stocks and bonds. Exposure to currencies increases the Sharpe ratio of diversified portfolios by 0.5 on average, while reducing crash risk. We argue that currency returns are an anomaly which is gradually being corrected as hedge fund capital increases.The appendix may be found here: http://ssrn.com/abstract=2771667.

Monetary Transmission in Low-Income Countries: Effectiveness and Policy Implications

Abstract: This paper reviews the monetary transmission mechanism in low-income countries (LICs). We use the standard description of monetary transmission as a benchmark to identify aspects of the transmission mechanism that may operate differently in LICs. In particular, the paper focuses on the effects of financial market structure on monetary transmission. The weak institutional framework prevalent in LICs drastically reduces the role of securities markets. Consequently, traditional monetary transmission through market interest rates and market-determined asset prices are weak or nonexistent. The exchange rate channel, in turn, tends to be undermined by heavy central bank intervention in the foreign exchange market. The weak institutional framework also has the effect of increasing the cost of bank lending to private firms. Coupled with imperfect competition in the banking sector, this induces banks to maintain chronically high excess reserves and to invest in domestic public bonds or (when possible) in foreign bonds. With the financial system not intermediating funds properly, the bank lending channel also becomes impaired. These factors undermine both the strength and reliability of monetary transmission, which has important implications for the conduct of monetary policy in LICs.

Oil Prices and Emerging Market Exchange Rates

Abstract: This paper investigates the role of oil prices in explaining the dynamics of selected emerging countries exchange rates. Using daily data series, the study concludes that a rise in oil price is leading to a significant appreciation in emerging economies currencies against the US dollar. In our study, we divide daily returns from 03/01/2003 to 02/06/2010 into 3 subsamples and test the role of oil price changes on exchange rate movements. We employ generalized impulse response functions to trace out the dynamic response of each exchange rate in three different time periods. Our findings suggest that oil price dynamics are changing significantly in the sample period and the relation between oil prices and exchange rates becomes more relevant after the 2008 financial crisis.

Dynamical clustering of exchange rates

Abstract: We use techniques from network science to study correlations in the foreign exchange (FX) market during the period 1991–2008. We consider an FX market network in which each node represents an exchange rate and each weighted edge represents a time-dependent correlation between the rates. To provide insights into the clustering of the exchange-rate time series, we investigate dynamic communities in the network. We show that there is a relationship between an exchange rate's functional role within the market and its position within its community and use a node-centric community analysis to track the temporal dynamics of such roles. This reveals which exchange rates dominate the market at particular times and also identifies exchange rates that experienced significant changes in market role. We also use the community dynamics to uncover major structural changes that occurred in the FX market. Our techniques are general and will be similarly useful for investigating correlations in other markets.

Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums

Abstract: Using a novel and comprehensive dataset, we provide the first systematic study of liquidity in the foreign exchange (FX) market. Contrary to common perceptions, we find significant variation in liquidity across exchange rates, substantial costs due to FX illiquidity, and strong commonality in the liquidities of different currencies. We analyze the impact of liquidity risk on the carry trade, which is a popular trading strategy that borrows in low interest rate currencies and invests in high interest rate currencies. We find that low (high) interest rate currencies tend to offer insurance against (exposure to) liquidity risk. A liquidity risk factor has a strong impact on daily carry trade returns from January 2007 to December 2009, suggesting that liquidity risk is priced in currency returns. Finally, we provide evidence that liquidity spirals may trigger these findings.

Decoding Social Influence and the Wisdom of the Crowd in Financial Trading Network

Abstract: In this paper, we study roles of social mechanisms in a financial system. Our data come from a novel on-line foreign exchange trading brokerage for individual investors, which also allows investors to form social network ties between each other and copy others' trades. From the dataset, we analyze the dynamics of this connected social influence systems in decision making processes. We discover that generally social trades outperform individual trades, but the social reputation of the top traders is not completely determined by their performance due to social feedback even when users are betting their own money. We also find that social influence plays a significant role in users' trades, especially decisions during periods of uncertainty. We report evidences suggesting that the dynamics of social influence contribute to market overreaction.

Two Targets, Two Instruments: Monetary and Exchange Rate Policies in Emerging Market Economies

Abstract: This paper examines the case for using two instruments—the policy interest rate and sterilized foreign exchange market intervention—in emerging market countries seeking to stabilize inflation and output while attenuating disequilibrium currency movements. We estimate policy reaction functions for central banks, documenting that indeed both instruments tend to be deployed. We show that whether discretionary monetary policy or inflation targeting is preferable depends on the volatility of shocks relative to the central bank's time inconsistency problem. The use of FX intervention as a second instrument improves welfare under both regimes, but more so under inflation targeting. Overall, a regime of (two-way) sterilized intervention-cum-inflation targeting can result in better outcomes in the presence of imperfect capital mobility/asset substitutability—yielding similar gains to a discretionary policy while still delivering the inflation target.

Flight-to-Quality and Correlation between Currency and Stock Returns

Abstract: In pair-wise analyses of a sample of 9 developed and 12 emerging markets, we find evidence that emerging country currencies are positively correlated with their stocks. Since return correlation between currency and its stocks has been shown to be weak or negative, this finding is somewhat surprising. We find that the numeraire currency used to measure currency returns is important in characterizing the return correlations. These strong ties between the currency and stock returns in emerging markets seem to be generated by international capital flows based on ‘flight-to-quality’ in down-markets. Since global equity markets are positively correlated, this implies that currencies provide a natural hedge for emerging country’s investors investing in developed countries. In other words, the currency market works an agent that shifts risks from the investors in emerging markets to those in the developed. If the goal of currency hedging is to reduce total return volatility from an international investment, investors from emerging markets should not hedge the currency risks when they invest in developed markets, while the converse is true for developed market investors investing in emerging markets. Using a unique sample of 27 ‘Siamese Twin’ international mutual fund pairs in Korea, which hold identical underlying foreign assets but offer different currency hedging alternatives, we find evidence that hedging currency risks actually undoes the natural hedge and increase the total return volatility.

Foreign Exchange Market Structure, Players and Evolution

Abstract: Electronic trading has transformed foreign exchange markets over the past decade, and the pace of innovation only accelerates. This formerly opaque market is now fairly transparent and transaction costs are only a fraction of their former level. Entirely new agents have joined the fray, including retail and high-frequency traders, while foreign exchange trading volumes have tripled. Market concentration among dealers has risen reflecting the heavy investments in technology. Undeterred, some new non-bank market participants have begun to make markets, challenging the traditional foreign exchange dealers on their own turf. This paper outlines the players in this market and the structure of their interactions. It also presents new evidence on how that structure has changed over the past two decades. Throughout, it highlights issues relevant to exchange rate modelling.

The Effectiveness of Forex Interventions in Four Latin American Countries

Abstract: Many central banks actively intervene in the foreign exchange (forex) market, although there is no consensus on its impact on the exchange rate level and volatility. We analyze the effects of daily forex interventions in four Latin American countries with inflation targets — namely, Chile, Colombia, Mexico and Peru — by fitting GARCH-type models. These countries represent a broad span of intervention strategies in terms of size and frequency, ranging from pure discretionality to intervention rules. We also provide new evidence on the presence of asymmetries, which arise if foreign currency purchases and sales have different effects on the exchange rate. We find that first interventions, either isolated or initial in a rule, reduce exchange rate volatility, although their size plays a minor role. Our results support the signaling effect of interventions under inflation targeting regimes.

The Causal Relationship between Exchange Rates and Stock Prices in Kenya

Abstract: This study examined the causal relationship between foreign exchange rates and stock prices in Kenya from November 1993 to May 1999. The data set consisted of monthly observations of the NSE stock price index and the nominal Kenya shillings per US dollar exchange rates. The objective was to establish the causal linkages between leading prices in the foreign exchange market and the Nairobi Securities Exchange (NSE). The empirical results show that foreign exchange rates and stock prices are nonstationary both in first differences and level forms, and the two variables are integrated of order one, in Kenya. Secondly, we tested for cointegration between exchange rates and stock prices. The results show that the two variables are cointegrated. Thirdly, we used error-correction models instead of the classical Granger-causality tests since the two variables are cointegrated. The empirical results indicate that exchange rates Granger-causes stock prices in Kenya. Keywords: Exchange rate, Stock prices, Causality, Unit root, Error-correction models, Kenya

Analysis of Macroeconomic Determinants of Exchange Rate Volatility in India

Abstract: The Foreign Exchange Market in India has undergone substantial changes over last decade. It is imperative by the excessive volatility of Indian Rupee causing its depreciation against major dominating currencies in international market. This research has been carried out in order to investigate various macroeconomic variables leading to acute variations in the exchange rate of a currency. An attempt has been made to review the probable reasons for the depreciation of the Rupee and analyse different macroeconomic determinants that have impact on the volatility of exchange rate and their extent of correlation with the same. Keywords: Exchange Rate; Inflation; Interest Rate; Foreign Exchange Market; Current Account; Exchange Rate Volatility; International Trade. JEL Classifications: F31; F41

India’s Trilemma: Financial Liberalisation, Exchange Rates and Monetary Policy1

Abstract: A key challenge for macroeconomic policy in open economies is how to simultaneously manage exchange rates, interest rates and capital account openness – the trilemma. This study calculates a trilemma index for India and investigates its evolution over time. We find that financial integration has increased markedly after the mid-2000s, with corresponding limitations on monetary independence (MI) and exchange rate stability (ES). In addition, we empirically confirm that a rise in one trilemma variable is traded off with a drop in the weighted sum of the other two, i.e. the trilemma configuration is binding in India. Finally, we consider the implications of changes in the trilemma index for macroeconomic outcomes. We find that greater MI systemically contributes to lower inflation, so the twin goals of ES and capital account openness may create policy dilemmas in particular economic environments. ES is associated with less inflation volatility, suggesting that there may be secondary benefits channelled through import and commodity prices. In these relationships, however, changes in international reserves are not statistically significant, suggesting that foreign exchange market intervention has not mitigated the trilemma trade-off in India.

Limited asset market participation and the consumption-real exchange rate anomaly

Abstract: Under efficient consumption risk sharing, as assumed in standard international business cycle models, a country’s aggregate consumption rises relative to foreign consumption, when the country’s real exchange rate depreciates. Yet, empirically, relative consumption and the real exchange rate are essentially uncorrelated. I show that this ‘consumption-real exchange rate anomaly’ can be explained by a simple model in which a subset of households trade in complete financial markets, while the remaining households lead hand-to-mouth (HTM) lives. HTM behavior also generates greater volatility of the real exchange rate and of net exports, which likewise brings the model closer to the data.

Speculation and hedging in the currency futures markets: Are they informative to the spot exchange rates

Abstract: This study presents an empirical analysis investigating the relationship between the futures trading activities of speculators and hedgers and the potential movements of major spot exchange rates. A set of trader position measures are employed as regression predictors, including the level and change of net positions, an investor sentiment index, extremely bullish/bearish sentiments, and the peak/trough indicators. We find that the peaks and troughs of net positions are generally useful predictors to the evolution of spot exchange rates, but other trader position measures are less correlated with future market movements. In addition, speculative position measures usually forecast price-continuations in spot rates while hedging position measures forecast price-reversals in these markets. © 2011 Wiley Periodicals, Inc. Jrl Fut Mark

Import tariff led export under-invoicing: A paradox

Abstract: Prolonged worldwide economic depression forces some economists and policy makers to demand tougher regulation to protect their domestic economy. If implemented, this may lead to a high-tariff regime that ruled the pre-globalised world economy. This paper examines the consequences of a tariff protected trade regime. It takes up the case of trade misreporting phenomena under the framework of protected regime. It builds up a basic trade mis-invoicing model and then develops collusion between underreporting traders of partner countries. I show that high tariff barrier gives incentives not only to the importers but also to the exporters to gain by underreporting the trade statistics. Interestingly, this paper shows that even if foreign exchange is fully floated, underground foreign exchange market can be created and exporters may rationally underreport without any gain through black market premium – a departure from conventional theory.

Exploring the dynamic interdependence between gold and other financial markets

Abstract: In this article, we explore the dynamic interdependence between gold and other financial markets by using an asymmetric dynamic conditional correlation model. The asymmetry in the dynamic conditional correlation is not recognized in many pair-wise assets and complimentary asymmetry is recognized only between gold and the euro/US dollar. In addition, we demonstrate that a structural break has occurred in the dynamic conditional correlation for the pair of gold and S&P500 index after the Lehman Brothers bankruptcy. Furthermore, we find evidence that although gold works as a safe haven in times of a stock market crash, its function is limited in the long run. We also show that the volatility index has a marginally significant explanatory power as the driving force behind the dynamic correlation between gold and the S&P500 index. This finding could be interpreted as a result of the flight to quality for gold through the recent financial turmoil.

How Do Exchange Rate Regimes Affect Firms' Incentives to Hedge Currency Risk? Micro Evidence for Latin America

Abstract: Using a unique dataset with information on the currency composition of firms' assets and liabilities in six Latin-American countries, I investigate how the choice of exchange rate regime affects firms' foreign currency borrowing decisions and the associated currency mismatches in their balance sheets. I find that after countries switch from pegged to floating exchange rate regimes, firms reduce their levels of foreign currency exposures, in two ways. First, they reduce the share of debt contracted in foreign currency. Second, firms match more systematically their foreign currency liabilities with assets denominated in foreign currency and export revenues--effectively reducing their vulnerability to exchange rate shocks. More broadly, the study provides novel evidence on the impact of exchange rate regimes on the level of un-hedged foreign currency debt in the corporate sector and thus on aggregate financial stability.

Local Volatility Pricing Models for Long-dated FX Derivatives

Abstract: We study the local volatility function in the Foreign Exchange market where both domestic and foreign interest rates are stochastic. This model is suitable to price long-dated FX derivatives. We derive the local volatility function and obtain several results that can be used for the calibration of this local volatility on the FX option's market. Then, we study an extension to obtain a more general volatility model and propose a calibration method for the local volatility associated to this model.

China's Financial System: Opportunities and Challenges

Abstract: We provide a comprehensive review of China's financial system, and explore directions of future development. First, the financial system has been dominated by a large banking sector. In recent years banks have made considerable progress in reducing the amount of non-performing loans and improving their efficiency. Second, the role of the stock market in allocating resources in the economy has been limited and ineffective. We discuss issues related to the further development of China's stock market and other financial markets. Third, the most successful part of the financial system, in terms of supporting the growth of the overall economy, is a non-standard sector that consists of alternative financing channels, governance mechanisms, and institutions. The co-existence of this sector with banks and markets can continue to support the growth of the Hybrid Sector (non-state, non-listed firms). Finally, among the policies that will help to sustain stable economic growth in China are those that reduce the likelihood of damaging financial crises, including a banking sector crisis, a real estate or stock market crash, and a "twin crisis" in the currency market and banking sector.