Higher Moments and Exchange Rate Behavior

This paper uses 15‐minute exchange rate returns data for the six most liquid currencies (i.e., the Australian dollar, British pound, Canadian dollar, Euro, Japanese yen, and Swiss franc) vis‐à‐vis the United States dollar to examine whether a GARCH model augmented with higher moments (HM‐GARCH) performs better than a traditional GARCH (TG) model. Two findings are unraveled. First, the inclusion of odd/even moments in modeling the return/variance improves the statistical performance of the HM‐GARCH model. Second, trading strategies that extract buy and sell trading signals based on exchange rate forecasts from HM‐GARCH models are more profitable than those that depend on TG models.     

Timing exchange rates using order flow: The case of the Loonie

This paper examines the relation between the Canadian dollar/US dollar (CAD) exchange rate and foreign exchange order flow employing a novel data set on CAD order flow over the period 1994–2005. We investigate empirically the predictive information content and the determinants of order flow. The results suggest that order flow has strong out-of-sample predictive power for CAD returns, yielding significant market timing ability and tangible economic gains in a stylized dynamic asset allocation context. In terms of its determinants, order flow appears to reflect not only the menu of macroeconomic variables typically suggested in the literature but is also closely related to commodity price fluctuations, as expected from a ‘commodity currency’.     

Exchange Rates and Monetary Policy Uncertainty

We document that a trading strategy that is short the U.S. dollar and long other currencies exhibits significantly larger excess returns on days with scheduled Federal Open Market Committee (FOMC) announcements. We show that these excess returns (i) are higher for currencies with higher interest rate differentials vis‐à‐vis the United States, (ii) increase with uncertainty about monetary policy, and (iii) increase further when the Federal Reserve adopts a policy of monetary easing. We interpret these excess returns as compensation for monetary policy uncertainty within a parsimonious model of constrained financiers who intermediate global demand for currencies.     

Optimal reserve composition in the presence of sudden stops

We analytically derive optimal central bank portfolios in a minimum variance framework with two assets and transaction demands caused by sudden stops in capital inflows. In this model, transaction demands become less important relative to traditional portfolio objectives as debt to reserve ratios decrease. We empirically estimate optimal dollar and euro shares for 23 emerging market countries and find that optimal reserve portfolios are dominated by anchor currencies and, at current debt-to-reserve ratios, introducing transaction demand has a relatively modest effect for most countries. We find that, in general, the dollar acts as a safe haven currency during sudden stops for country specific and global sudden stops, increasing the optimal share of dollar bonds in central bank portfolios. Correspondingly, our model predicts that dollar shares should decline as debt-to-reserve ratios fall, as observed in recent data. We also find that the denomination of foreign currency debt has little importance for optimal reserve portfolios.     

A New Method for Identifying the Effects of Foreign Exchange Interventions

Central banks react even to intraday changes in the exchange rate; however, in most cases, intervention data are available only at a daily frequency. This temporal aggregation makes it difficult to identify the effects of interventions on the exchange rate. We apply the Bayesian Markov‐chain Monte Carlo (MCMC) approach to this endogeneity problem. We use “data augmentation” to obtain intraday intervention amounts and estimate the efficacy of interventions using the augmented data. Applying this new method to Japanese data, we find that an intervention of 1 trillion yen moves the yen/dollar rate by 1.8%, which is more than twice as much as the magnitude reported in previous studies applying ordinary least squares to daily observations. This shows the quantitative importance of the endogeneity problem due to temporal aggregation.     

The efficiency of the information processing in the Australian dollar market: Price discovery following scheduled and unscheduled news

We jointly investigate the responses of the Australian dollar (AUD) order flow, realized volatility and trading volume to unscheduled Reuters news headline alerts and scheduled macroeconomic news from Australia, Japan, the Eurozone, the U.K., and the U.S. over the period 2 January 2007 to 31 December 2009. We find that Reuters foreign exchange and fixed income market news headlines are important, and those headlines that arrive during the Australian offshore trading hours matter more. Furthermore, the AUD market responded mostly to Australian and U.S. macroeconomic news which have direct relevance for the exchange rate. We also find that better than expected Japanese and Eurozone macroeconomic news elicited a response in the AUD and also that better than expected news from Australia, U.S. and U.K. matter more. Finally, we find that the volume response to news decreases at a slower rate than the volatility response and that order flows for the AUD respond only to scheduled news.     

European Foreign Exchange Risk Exposure

We find that about 13% of our sample of 817 European multinational firms experienced economically significant exposure effects to the Japanese yen, 14% to the US dollar and 22% to the UK pound. Our evidence differs substantially from the US experience and is robust across sub‐sample periods, suggesting that a depreciating (appreciating) euro against foreign currencies has a net negative (positive) impact on European stock returns. Short‐term exposure seems to be relatively well hedged, where considerable evidence of long‐term exposure is found. Firms with weak liquidity positions tend to have smaller exposures. Foreign exposure is found to increase with firm size.     

Financial Stress Regimes and the Macroeconomy

Some financial stress events lead to macroeconomic downturns, while others appear to be isolated to financial markets. We identify financial stress regimes using a model that explicitly links financial variables to macro‐economic outcomes. The stress regimes are identified using an unbalanced panel of financial variables with an embedded method for variable selection. Our identified stress regimes are associated with corporate credit tightening and with NBER recessions. An exogenous deterioration in our financial conditions index has strong negative effects in economic activity, and negative amplification effects on inflation in the stress regime. These results are obtained with a novel factor‐augmented vector autoregressive model with smooth‐transition regimes (FASTVAR).     

The impact of exchange rate deviations from relative PPP equilibrium on the U.S. demand for foreign equities

Applying fixed-effects panel data, this study investigates the impact of U.S. dollar exchange rate movements during different exchange rate states (overvaluation and undervaluation) on the monthly real gross and real net purchases of foreign equities by U.S. residents over the post-Plaza Accord period. The foreign equities come from 22 developed and 25 developing countries. Previous research has posited two alternative hypotheses regarding the relationship between exchange rates and foreign investment. These are the wealth effect and the profit-oriented effect. The evidence herein suggests that these two hypotheses coexist. We find robust evidence for a negative relationship between the exchange rate movements of an undervalued U.S. dollar and the demand for foreign equities. For developed countries, the wealth effect dominates the profit-oriented effect when the U.S. dollar is overvalued, while, for developing countries, the profit-oriented effect dominates the wealth effect. The results emphasize the importance of considering exchange rate states derived from a relative PPP equilibrium when analyzing U.S. allocations to foreign equities. The findings with respect to the macroeconomic control variables are mainly in agreement with the predictions of international financial theory. Some of the results, however, disappear or become inconclusive for the period after the bankruptcy of Lehman Brothers. This may be explained by the increased uncertainty in international financial markets following this unprecedented event. The findings are robust with respect to different constructed equilibrium exchange rates.     

Macroeconomic news and exchange rates

This paper examines the relationship between macroeconomic news and the dollar–Mark and dollar–Yen exchange rates. We employ high-frequency observations for a 10-year period. We investigate whether exchange rate observations need to be sampled at a high frequency in order to detect significant effects from news announcements on mean returns and volatility. We examine the linearity and symmetry of the responses to news and also allow the effects of the news announcements to vary across states of the economy. We find that news indicating a stronger U.S. economy causes an appreciation of the U.S. dollar, that the responses are essentially complete within 5 min, and that measuring the responses over 6-h intervals eliminates the statistical significance of the news. The effects of news appear linear and symmetric but there is some evidence that the effects depend on the state of the economy.     

Global liquidity risk in the foreign exchange market

Using a broad data set of 20 US dollar exchange rates and order flow of institutional investors over 14 years, we construct a measure of global liquidity risk in the foreign exchange (FX) market. Our FX liquidity measure may be seen as the analog of the well-known Pastor–Stambaugh liquidity measure for the US stock market. We show that this measure has reasonable properties, and that there is a strong common component in liquidity across currencies. Finally, we provide evidence that liquidity risk is priced in the cross-section of currency returns, and estimate the liquidity risk premium in the FX market around 4.7 percent per annum.     

On the sources of private information in FX markets

We investigate the source of information advantage in inter-dealer FX trading using data on trades and counter-party identities. In liquid dollar exchange rates, information is concentrated among dealers that trade most frequently and specialize their activity in a particular rate. In cross-rates, traders that engage in triangular arbitrage are best informed. Better-informed traders are also located on larger trading floors. In cross-rates, the ability to forecast flows explains all of the advantage of the triangular arbitrageurs. In liquid dollar rates, specialist traders can forecast both order-flow and the component of exchange rate changes that is uncorrelated with flow.     

A test of the stability of exchange rate risk: Evidence from the Australian equities market

This paper investigates the sensitivity of equity returns on Australian industry portfolios to an exchange rate factor for the period 1988–1998. Specifically, using daily data, we (1) analyse the exchange rate exposure of the Australian equities market by implementing a basic augmented market model using relevant bilateral exchange rates, (2) investigate the intertemporal stability of the exchange rate exposure by using a dummy variable specification, and (3) attempt to establish the determinants of the exchange rate exposure of Australian industries by undertaking a cross-sectional analysis. A further empirical issue addressed by our study is that of whether the sensitivity is contemporaneous or lagged. We find (a) some evidence of exchange rate exposure, (b) some evidence of intertemporal sensitivity, and (c) a greater sensitivity to movements in the Australian dollar/US dollar exchange rate factor than to movements in the Australian dollar/Japanese yen. Further, we observe a significant lagged effect when employing the basic augmented model. This difference in the response of the industry portfolio returns is not observed, however, in our intertemporal stability investigation. Finally, we do not find significant evidence in terms of the cross-sectional determinants of foreign exchange exposure.     

Forecasting foreign exchange rates using idiosyncratic volatility

Average idiosyncratic stock volatility forecasts the bilateral exchange rates of the US dollar against major foreign currencies in and out of sample. The US dollar tends to appreciate after an increase in US idiosyncratic volatility. Similarly, ceteris paribus, German and Japanese idiosyncratic volatilities positively and significantly correlate with future US dollar prices of the Deutsche mark and the Japanese yen, respectively. Our results suggest that exchange rates are predictable.     

Countercyclical currency risk premia

We describe a novel currency investment strategy, the ‘dollar carry trade,’ which delivers large excess returns, uncorrelated with the returns on well-known carry trade strategies. Using a no-arbitrage model of exchange rates we show that these excess returns compensate U.S. investors for taking on aggregate risk by shorting the dollar in bad times, when the U.S. price of risk is high. The countercyclical variation in risk premia leads to strong return predictability: the average forward discount and U.S. industrial production growth rates forecast up to 25% of the dollar return variation at the one-year horizon. The estimated model implies that the variation in the exposure of U.S. investors to worldwide risk is the key driver of predictability.     

Frequency of observation and the estimation of integrated volatility in deep and liquid financial markets

Using two newly available ultrahigh-frequency datasets, we investigate empirically how frequently one can sample certain foreign exchange and U.S. Treasury security returns without contaminating estimates of their integrated volatility with market microstructure noise. Using the standard realized volatility estimator, we find that one can sample dollar/euro returns as frequently as once every 15 to 20 s without contaminating estimates of integrated volatility; 10-year Treasury note returns may be sampled as frequently as once every 2 to 3 min on days without U.S. macroeconomic announcements, and as frequently as once every 40 s on announcement days. Using a simple realized kernel estimator, this sampling frequency can be increased to once every 2 to 5 s for dollar/euro returns and to about once every 30 to 40 s for T-note returns. These sampling frequencies, especially in the case of dollar/euro returns, are much higher than those that are generally recommended in the empirical literature on realized volatility in equity markets. The higher sampling frequencies for dollar/euro and T-note returns likely reflect the superior depth and liquidity of these markets.     

An international CAPM for partially integrated markets: Theory and empirical evidence

This article proposes a theoretical testable capital asset pricing model for partially segmented markets. We establish that if some investors do not hold all international assets because of direct and/or indirect barriers, the world market portfolio is not efficient and the traditional international CAPM must be augmented by a new factor reflecting the local risk undiversifiable internationally. We also introduce a suitable framework to test this model empirically. Using a sample of six emerging markets and three mature markets, we find that the degree of stock market integration varies through time and that most of the sample emerging markets have become more integrated in the recent years. The local risk premium for emerging markets represents the most important component of the total risk premium, but its relative importance has decreased recently. Differently, the total risk premium for developed countries is largely driven by global factors.     

Evolving Macroeconomic Dynamics in a Small Open Economy: An Estimated Markov Switching DSGE Model for the UK

This paper investigates the possibility of shifts in the UK economy using a Markov switching open economy dynamic stochastic general equilibrium (DSGE) model. We find overwhelming evidence to reject the hypothesis that the deep structural parameters of the underlying structural model had stayed constant throughout the sample period and there is significant changes to the volatility of the structural shocks. Counterfactual experiments based on the model with the best empirical fit indicate that the change in the policy rule as well as changes to the volatility of the structural shocks over the sample period are crucial features in explaining UK’s macroeconomic performance.     

Macroeconomic Shocks and Banks' Foreign Assets

Recent developments in international financial markets have highlighted the role of banks in the transmission of shocks across borders. We employ dynamic panel methods for a sample of OECD countries to analyze whether banks' foreign assets react to macroeconomic shocks at home and abroad. We find that banks reduce their foreign assets in response to a relative increase in domestic interest rates, and they increase their foreign assets when the growth rate of world energy prices rises. The responses are characterized by a temporal overshooting and a dynamic adjustment process that extends over several quarters.     

Rational speculation and exchange rates

Models of exchange rates have typically failed to produce results consistent with the key fact that real and nominal exchange rates move in ways not closely connected to current (or past) macroeconomic variables. Models that rely on the same shocks to drive fluctuations in macroeconomic variables and exchange rates typically imply counterfactually-strong co-movements between them. We develop a model in which new information leads agents to change their rational beliefs about risk premia on foreign exchange markets. These changes in risk premia work through asset markets to cause real and nominal exchange rates to change without corresponding changes in GDP, productivity, money supplies, and other key macro variables.