Interest Rates and Exchange Rate Movements: Analyzing Short-term Investments in Long-term Bonds

Tests of the uncovered interest rate parity (UIP) are subject to various data problems when long-term interest rates are applied: due to the long investment period, time intervals for measuring exchange rate movements are usually overlapping and therefore not independent. This shortfall can be prevented by considering short-term investments in long-term bonds instead of investments to maturity. This article analyzes the explanatory power of long-term interest rates with regard to 1- and 3-month exchange rate movements by relating return differences from 1- and 3-month investments in domestic and foreign 10-year government bonds to nine different exchange rates. From a Swiss perspective, there is only weak support for an interrelation between return differences and the corresponding exchange rate movements, whereas from a US perspective, the resulting estimates are much more in line with UIP.The reader may for instance consider Engel (1996) and Froot and Thaler (1990).     

Differential risk premiums and the UIP puzzle

We respecify the uncovered interest rate parity (UIP) conditions by inverting the market price of the risk (Sharpe ratio) formula. Our empirical model provides new insight indicating that violations to the UIP stem from the existence of a risk premium in the exchange rates and from observed market return differentials being a noisy statistic of the markets’ expected return differentials in our respecified model. Using an integrated macro‐micro structure framework for expected market return differentials improves our model fit and the validity of UIP.     

Uncovered interest parity: The long and the short of it

Uncovered interest rate parity (UIP) is a theoretical relation linking changes in exchange rates and corresponding interest rate differentials. Despite its considerable intellectual appeal, uncovered interest rate parity has very often been found wanting empirically. I reinvestigate this relation using a 17-country panel of historical time series data at its longest—for the US–UK country pair—spanning 217 years. I find results that are largely consistent with theory: over the long term, in most countries, bond yields expressed in common currency bear a positive relationship to one another as UIP predicts. This is in contrast to the very nearly opposite findings reported in much of the literature and now taken as a stylized fact.     

An empirical study of nonlinear adjustment in the UIP model using a smooth transition regression model

This study considers the nonlinear relationship between the expected exchange rate change and the interest rate differential, using STR models (ESTR and LSTR), with Sharpe ratios, interest rate differentials and exchange rate volatilities as the transition variables. The results generally conclude that UIP holds with the larger Sharpe ratio and higher exchange rate volatility regimes, which is consistent with the transaction costs and limits to speculation hypotheses. However, the interest rate differential (which is generally not used much as a transition variable) when used in this study results in a failure to support UIP in the upper regime, which suggests it is the risk not the pure return that determines the transition.     

Price Stability in Economies with Habit Persistence

This paper shows that the divine‐coincidence does not hold in a sticky price model with external habit if a time‐varying tax rate on labor income is not implemented to fully eliminate the time‐varying distortions associated with external habit and monopoly power in goods market. The required labor income tax rate is inversely related to the risk‐free real interest rate and the markup in the goods market, but it is proportional to the degree of external habit. Under this circumstance, the optimal monetary policy commands a countercyclical interest rate, having a perfect negative correlation with tax rate in the sticky price model with external habit. If a time‐invariant tax is the only fiscal instrument, then the degree of external habit entails a gap between the private marginal rate of substitution between consumption and labor and the social marginal rate of substitution, generating an endogenous trade‐off between the stabilization of welfare‐relevant output gap and inflation. Under this circumstance, price stability is not the optimal policy. The monetary policy authority should optimally try to undo the time‐varying distortions associated with external habit and monopoly power in goods market by deviating from price stability.     

Predicting exchange rate cycles utilizing risk factors

This paper attempts to predict the cyclical behavior of exchange rates by using five risk factors, viz., violations of uncovered interest rate parity (UIP), relative purchasing power parity (RPPP) and pseudo-parity for equity returns, relative (cross-country) TED spreads and relative term spreads. These factors are found to forecast periods of depreciation or appreciation and subsequent reversals. The estimates based on a dynamic probit model reveal that violations of UIP, RPPP and equity market pseudo-parity exhibit predictive power for currency cycles albeit only at short horizons. The proposed framework can be utilized by policy makers to smoothen the resulting currency misalignment and by investors to form trading strategies and hedge their positions as well as re-balance their carry trade positions.     

Uncovered Interest Parity,Forward Guidance and the Exchange Rate

Under uncovered interest parity (UIP), the size of the effect on the real exchange rate of an anticipated change in real interest rate differentials is invariant to the horizon at which the change is expected. Empirical evidence using U.S., euro area and UK data points to a substantial deviation from that invariance prediction: expectations of interest rate differentials in the near (distant) future are shown to have much larger (smaller) effects on the real exchange rate than is implied by UIP. Some possible explanations are discussed.     

Home bias,exchange rate disconnect,and optimal exchange rate policy

This paper examines how much the central bank should adjust the interest rate in response to real exchange rate fluctuations. The paper first demonstrates, in a two-country Dynamic Stochastic General Equilibrium (DSGE) model, that home bias in consumption is important to replicate the exchange rate volatility and exchange rate disconnect documented in the data. When home bias is high, the shock to Uncovered Interest rate Parity (UIP) can substantially drive up exchange rate volatility while leaving the volatility of real macroeconomic variables, such as GDP, almost untouched. The model predicts that the volatility of the real exchange rate relative to that of GDP increases with the extent of home bias. This relation is supported by the data. A second-order accurate solution method is employed to find the optimal operational monetary policy rule. Our model suggests that the monetary authority should not seek to vigorously stabilize exchange rate fluctuations. In particular, when the central bank does not take a strong stance against the inflation rate, exchange rate stabilization may induce substantial welfare loss. The model does not detect welfare gain from international monetary cooperation, which extends Obstfeld and Rogoff's [Obstfeld, M., Rogoff, K.,2002. Global implications of self-oriented national monetary rules, Quarterly Journal of Economics May, 503–535] findings to a DSGE model.     

A Habit-Based Explanation of the Exchange Rate Risk Premium

This paper presents a model that reproduces the uncovered interest rate parity puzzle. Investors have preferences with external habits. Countercyclical risk premia and procyclical real interest rates arise endogenously. During bad times at home, when domestic consumption is close to the habit level, the representative investor is very risk averse. When the domestic investor is more risk averse than her foreign counterpart, the exchange rate is closely tied to domestic consumption growth shocks. The domestic investor therefore expects a positive currency excess return. Because interest rates are low in bad times, expected currency excess returns increase with interest rate differentials.     

The valuation of catastrophe bonds with exposure to currency exchange risk

In this paper, we present a new model that takes an arbitrage approach to the valuation of catastrophic risk bonds (CAT bonds). The model considers the sponsor's exposure to currency exchange risk and the risk of catastrophic events. We use a jump-diffusion process for catastrophic events, a three-dimensional stochastic process for the exchange rate and domestic and foreign interest rates, and a hedging cost for the currency risk to derive a semi-closed-form formula for the CAT bond price. We also extend to three factors Joshi and Leung's (2007) Monte Carlo simulation approach to obtain numerical results showing the following: in addition to catastrophic risk, the CAT bond price is affected mainly by the volatility of the exchange rate and its correlations with domestic and foreign interest rates. The first two factors have a negative impact while the third has a positive impact.     

Solving exchange rate puzzles with neither sticky prices nor trade costs

We present a simple framework in which both the exchange rates disconnect and forward bias puzzles are simultaneously resolved. The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Habit persistence is modeled using Campbell Cochrane preferences with ‘deep’ habits along the lines of the work of Ravn, Schmitt-Grohe and Uribe. By deep habits, we mean habits defined over goods rather than countries. The model is simulated using the artificial economy methodology. It offers a neo-classical explanation of the Meese–Rogoff puzzle and mimics the failure of fundamentals to explain nominal exchange rates in a linear setting. Finally, the model naturally generates the negative slope in the standard forward market regression.     

Stock Volatility and the Levels of the Basis and Open Interest in Futures Contracts

This article tests a theoretical model of the basis and open interest of stock index futures. The model is based on the differences between stock and futures in terms of investors' ability to customize stock portfolios and liquidity. Empirical evidence confirms the model's prediction that increased volatility decreases the basis and increases open interest.     

How does institutional investors' information acquisition inhibit share pledging? Evidence from China

This study investigates whether and how institutional investors' information acquisition affects controlling shareholder's share pledging. Taking a unique data of institutional investors' corporate site visits in China, we find that institutional investors' corporate site visits significantly inhibit controlling shareholder's share pledging. This effect is robust to a series of robustness checks, including controlling for endogeneity concerns, propensity score matching method, alternative model specifications, and alternative measures of the independent variable. We then provide evidence that the negative relation between institutional investors' corporate site visits and controlling shareholder's share pledging is more pronounced for listed firms with less efficient information environment and weaker corporate governance. Further analysis indicates that the negative relation is also more pronounced when controlling shareholders are under higher margin call pressure and when the visiting institutional investors consist of more fund companies. Overall, our study is the first to provide direct evidence of the governance mechanism of financial intermediaries on shareholders' pledging decisions.     

The Share of Systematic Variation in Bilateral Exchange Rates

Sorting countries by their dollar currency betas produces a novel cross section of average currency excess returns. A slope factor (long in high beta currencies and short in low beta currencies) accounts for this cross section of currency risk premia. This slope factor is orthogonal to the high‐minus‐low carry trade factor built from portfolios of countries sorted by their interest rates. The two high‐minus‐low risk factors account for 18% to 80% of the monthly exchange rate movements. The two risk factors suggest that stochastic discount factors in complete markets' models should feature at least two global shocks to describe exchange rates.     

The impacts of investors' sentiments on stock returns using fintech approaches

This study uses fintech approaches, including web crawler technology with distributed architecture to select internet news messages largely and efficiently and a dictionary-based linguistic text mining to create sentiment variables, to explore the respective impacts of investors' optimism and pessimism on stock returns. The construction of sentiment variables in network- and dictionary-based messages is more precise and variable than that in traditional-based messages. Our results show that firms with investors' optimistic sentiments have significantly higher stock returns in the current month, whereas those with pessimistic sentiments have significantly opposite effects. The effect of both investors' optimism and pessimism on stock returns subsequently reverses. Then, the negative impacts of investors' largely pessimistic sentiments on stock returns are larger than the positive impacts of their largely optimistic sentiments within a quarter. Next, investors' optimistic sentiments significantly raise stock return volatility by approximately a quarter, but their pessimistic sentiments have the opposite effects. Furthermore, investors' high optimism more significantly and persistently raises stock return volatility than their general optimism, but the negative effects of their high pessimism on volatility become smaller and the persistence is shorter than general pessimism. In addition to the advantage of our methodology in creating sentiment variables, the simultaneous consideration of investors' optimism and pessimism to analyze the effects on the returns and the volatility of individual stocks in this study is more complete than previous related studies.     

汇率敏感性会影响企业贷款利率吗？——基于中国上市公司的分析

本文基于中国A股上市公司2009-2018年的数据,测算了企业价值对人民币汇率变动的敏感性。在此基础上,实证检验了汇率敏感性(企业价值对汇率变动的敏感程度)对企业贷款利率的影响和作用机制。研究发现:汇率敏感性与企业贷款利率之间显著正相关,且这种关系在拥有境外收入、境外投资和使用外汇衍生品的公司中更加显著。进一步分析发现,对于存在密切银企关系、较大的股东债权人利益冲突以及抵押品价值较低的企业,汇率敏感性与贷款利率之间的正相关关系更加显著。本文研究结果表明,随着我国市场化改革的进一步深化,贷款利率将会更加显著地反映企业的汇率敏感性特征。这种效应对于存在海外业务、银行更了解借款公司信息,以及违约可能性更高的公司更加明显。本文研究对于增强我国企业应对汇率风险能力,完善金融机构风险定价能力,引导金融机构服务实体企业具有一定参考意义。     

Testing PPP Hypotheses between Japan and the Six G7 Countries

The paper examines the purchasing power parity(PPP) theory of the foreign exchange rate of the yenagainst the currencies of the six G7 countries. We usethe error-corrected five-dimensional vectorautoregressive (VAR) model with structural changes inthe trend function. The data cover the period of thepost-Breton–Woods floating exchange rate system. Theresults reveal that the PPP relation alone determinesthe exchange rates for the USA, France, Germany, andItaly, while a linear combination of PPP and uncoveredinterest rate parity (UIP) relations determines that for Canada. Ina model without trend breaks, the PPP relations holdonly for Germany, which indicates that a correctspecification of the sampling distribution of data isimportant. The one-step prediction based on the errorcorrection model (ECM) outperforms the random walkmodel. The ECM is useful to predict the out-of-samplebehaviors of the exchange rates.     

Stochastic intramarginal interventions in target zones

In this paper, we develop an exchange rate target zone model with stochastic intramarginal interventions that generalizes Krugman's standard model. We assume that money supply changes are (negative) proportional to the velocity shocks. The model produces realistic patterns for the relationship among exchange rate, fundamentals and interest rate differentials, which can explain some empirical failures of previous target zone models. The main result derived from the model is that non-linearities in the behavior of both exchange rate and interest rate differential disappear as intramarginal interventions increase.     

Can negative interest rates really affect option pricing? Empirical evidence from an explicitly solvable stochastic volatility model

The profound financial crisis generated by the collapse of Lehman Brothers and the European sovereign debt crisis in 2011 have caused negative values of government bond yields both in the USA and in the EURO area. This paper investigates whether the use of models which allow for negative interest rates can improve option pricing and implied volatility forecasting. This is done with special attention to foreign exchange and index options. To this end, we carried out an empirical analysis on the prices of call and put options on the US S&P 500 index and Eurodollar futures using a generalization of the Heston model in the stochastic interest rate framework. Specifically, the dynamics of the option’s underlying asset is described by two factors: a stochastic variance and a stochastic interest rate. The volatility is not allowed to be negative, but the interest rate is. Explicit formulas for the transition probability density function and moments are derived. These formulas are used to estimate the model parameters efficiently. Three empirical analyses are illustrated. The first two show that the use of models which allow for negative interest rates can efficiently reproduce implied volatility and forecast option prices (i.e. S&P index and foreign exchange options). The last studies how the US three-month government bond yield affects the US S&P 500 index.     

Habit Formation and Macroeconomic Models of the Term Structure of Interest Rates

This paper introduces a new class of nonaffine models of the term structure of interest rates that is supported by an economy with habit formation. Distinguishing features of the model are that the interest rate dynamics are nonlinear, interest rates depend on lagged monetary and consumption shocks, and the price of risk is not a constant multiple of interest rate volatility. We find that habit persistence can help reproduce the nonlinearity of the spot rate process, the documented deviations from the expectations hypothesis, the persistence of the conditional volatility of interest rates, and the lead‐lag relationship between interest rates and monetary aggregates.