Oil market uncertainty and excess returns on currency carry trade

This paper examines the role of oil market uncertainty on currency carry trade payoffs. We find that oil market uncertainty can impact currency carry trade excess returns. When oil market uncertainty rises, expected currency excess returns will increase. Our findings are robust to alternative measures of oil market uncertainty and, after controlling for traditional uncertainties, different types of oil shocks. The results also hold well in both developed and emerging markets, as well as for oil-related currencies, non-oil currencies, commodity currencies, and non-commodity currencies. Additionally, oil market uncertainty can be priced in the cross section of currency carry trade excess returns. This effect can be explained by investors becoming more risk averse under high oil market uncertainty and requiring greater compensation for bearing such risk. Moreover, our measure of oil market uncertainty, the downside risk from the oil market, is quite different from that of traditional aggregate measures.     

Foreign participation in local currency bond markets

Countries that cannot attract foreigners to invest in their local currency bonds run the risk of currency mismatches that can result in painful crises. We analyze foreign participation in the bond markets of over 40 countries. Bond markets in less developed countries have returns characterized by high variance and negative skewness, factors that we show are eschewed by U.S. investors. While results based on a three-moment CAPM indicate that it is diversifiable idiosyncratic risk that U.S. investors shun, our analysis suggests that countries can improve foreign participation by reducing macroeconomic instability.     

Currency hedging for single-currency equity portfolios: Does cross-asset risk matter?

Foreign investors who are fully invested in a single-currency domestic equity portfolio are exposed to domestic equity risk, but also to currency risk. The standard approach to hedging the currency risk optimally is to estimate a single optimal hedge ratio, but this approach hedges only exchange rate risk, not cross-asset risk. We provide an alternative approach that estimates two optimal hedge ratios to adjust the currency exposures—one associated with the domestic currency and one associated with the foreign currency—and hedges both exchange rate risk and cross-asset risk. This alternative approach can significantly reduce risk.     

Is Bitcoin a better portfolio diversifier than gold? A copula and sectoral analysis for China

This paper aims to compare Bitcoin with gold in the diversification of Chinese portfolios using daily data over the 2010–2020 period. We propose a new development of copula-based joint distribution function of returns to simulate the Value-at-Risk and expected shortfall of portfolios including Bitcoin (or gold) and those without it. The stochastic dominance method is also used to compare the return distributions of the three types of portfolios. Empirical results show that gold is a better portfolio diversifier than Bitcoin as it helps better reduce the risk of portfolios. On the other hand, Bitcoin better increases the return but also increases the risk. The stochastic dominance results further show that portfolios diversified by gold dominate those diversified by Bitcoin. Based on these findings, we conclude that in China, gold is a better portfolio diversifier than Bitcoin for risk-averse investors. However, for risk-seeking investors, Bitcoin can be a better choice. This result is found to be robust to the time, frequency and currency effects.     

Foreign exchange risk pricing and equity market segmentation in Africa

This work is the first to investigate simultaneously the occurrence of unconditional currency risk pricing and equity market segmentation in Africa’s major stock markets. The multi-factor asset pricing theory provides the theoretical framework for our model. We find strong evidence suggesting that Africa’s equity markets are partially segmented. However, we find insufficient evidence to reject the hypothesis that foreign exchange risk is not unconditionally priced in Africa’s stock markets. This result is robust to alternative foreign exchange rate-adjusted return measures. These findings suggest that international investors can diversify into Africa’s equity markets without worrying about unconditional risks associated with foreign exchange rate fluctuations.     

The unsung impact of currency risk on the performance of international real property investment

The paper revisits the currency risk debate to ascertain the statistical significance of currency risk on the return of international real property investment, especially in a period of increased exchange rate volatility. After statistical analyses of the returns of a portfolio of office investments in seven Asia Pacific cities over the 1986 to 2007 period, it was found that currency risk had a statistically significant positive impact on the performance of the portfolio of office investments. This is confirmed by the results of stochastic dominance test. If the results of this study are verified by subsequent studies, and the past reliably presages the future, they would imply that investors holding portfolios of real property investments in the sample markets might not need to be unduly concerned with currency risk.     

Asymmetric currency exposure and currency risk pricing

Whether stock returns are linked to currency movements and whether currency risk is priced in a domestic context are less conclusive and thus still subject to a great debate. Based on a different approach, this paper attempts to provide new empirical evidence on these two inter-related issues, which are critical to investors and corporate risk management. In particular, this paper not only explores the possibility of asymmetric currency exposure that may explain why prior studies, which focus exclusively on linear exposure, have difficulty in detecting it, but also tests whether this asymmetric currency exposure is priced. The results show strong evidence of asymmetric currency exposure and currency risk pricing, suggesting that both asymmetry and conditional heteroskedasticity play important roles in testing currency exposure and its price.     

The pricing of foreign exchange risk around the Asian financial crisis: evidence from Taiwan's stock market

The volatile exchange rate movement during the Asian financial crisis has led global investors to re-evaluate the importance of currency exposures in Asian stock markets. In this paper, we examine industry-level currency risk of Taiwan's stock market around the Asian financial crisis. The results show that most export-oriented industries, except for the electronics industry, are positively affected by the depreciation of the New Taiwan Dollars (NTD) against the US Dollars (USD). We also find that the magnitude of currency risk is less for banking and electronics industries in the Taiwan Stock Exchange (TSE) than for those in the over-the-counter (OTC) security exchange. Our results are consistent with the findings of Chow et al. (J. Financial Res. 2 (1997b) 191) and have important implications for international investors with exposures in Taiwan's stock market.     

Equilibrium Exchange Rate Hedging

We assume a world like the one that gives the capital asset pricing model, but with many goods and many countries. We assume that investors in a given country have homothetic utility functions with the same weights, and a currency that has a sure end-of-period value using a price index with those weights. Siegel's paradox (derived from Jensen's inequality) makes investors want a positive amount of exchange risk. When average risk tolerance is the same across countries, every investor will hold the same mix of market risk (through the world market portfolio of all assets) and exchange risk (in a diversified basket of foreign currencies). In fact, the ratio of exchange risk to market risk is equal to the average investor's risk tolerance. We can write the ratio of exchange risk to market risk (and the fraction of the market's exchange risk that investors hedge) as depending on an average of world market risk premia, an average of world market volatilities, and an average of exchange rate volatilities. The weights in these averages are the same as the weights of the different countries in the currency basket. Given these averages, the ratio (and the fraction hedged) will not depend directly on exchange rate means or covariances. In equilibrium, we can use the ratio of exchange risk to market risk to measure average risk tolerance: in this model, risk tolerance is observable.     

Safehavenness of currencies

This study assesses the ‘safehavenness’ of a number of currencies with a view to providing a better understanding of how capital flow tends to react to a sharp increase in global risk aversion in turbulent times. It focuses on how the currencies are perceived by international investors or, more specifically, whether they are seen as safe-haven or risky currencies. To assess the safehavenness of the currency, we use risk reversal, which is the price difference between the call and put options of a currency, as it reflects how disproportionately market participants are willing to pay to hedge against its appreciation or depreciation. The relationship between the risk reversal of the currency and global risk aversion is estimated by means of parametric and non-parametric regressions that allow us to capture currency behaviour in times of extreme adversity, that is, the tail risk. Our empirical results found the Japanese yen and, to a lesser extent, the Hong Kong dollar to be the only safe havens under stressful conditions among the 34 currencies vis-à-vis the US dollar.     

The ADR shadow exchange rate as an early warning indicator for currency crises

We develop an indicator for currency crisis risk using price spreads between American Depositary Receipts (ADRs) and their underlyings. This risk measure represents the mean exchange rate ADR investors expect after a potential currency crisis or realignment. It makes crisis prediction possible on a daily basis as depreciation expectations are reflected in ADR market prices. Using daily data, we analyze the impact of several risk drivers related to standard currency crisis theories and find that ADR investors perceive higher currency crisis risk when export commodity prices fall, trading partners’ currencies depreciate, sovereign yield spreads increase, or interest rate spreads widen.     

Uncovered Equity Parity and rebalancing in international portfolios

Portfolio rebalancing is a key driver of the Uncovered Equity Parity (UEP) condition. According to UEP, when foreign equity holdings outperform domestic holdings, domestic investors are exposed to higher exchange rate exposure and hence repatriate some of the foreign equity to decrease their exchange rate risk. By doing so, foreign currency is sold, leading to foreign currency depreciation. We examine the relationship between U.S. investors' portfolio reallocations and returns and find some evidence consistent with UEP: Portfolio shifts are related to past returns in the underlying equity markets. But we argue that a motive other than reducing currency risk exposure is likely behind this rebalancing. In particular, U.S. investors rebalance away from equity markets that recently performed well and move into equity markets just prior to relatively strong performance, suggesting tactical reallocations to increase returns rather than reduce risk.     

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.     

Behavioral currency hedging for international portfolios

The purpose of this paper is to incorporate behavioral issues as it relates to the active currency hedging of international portfolios in the context of traditional expected utility maximization approach. The uniqueness of the approach is that separate risk aversion parameters are introduced for asset and currency markets. The paper is similar in spirit to Black (Black, F. 1989, Universal hedging, Financial Analysts Journal (July-August), 16-22.), who argued that a portion of foreign equity investments should be permanently unhedged, which is basically postulating that one should take a buy-and-hold position in currency with a fraction of the capital. The behavioral twist included in the traditional expected utility maximization approach results in lower hedge ratios, ceteris paribus, partly due to the asymmetric nature of the compensation structure of currency managers.Since the asymmetric nature of incentive schemes of asset and currency managers dictates how one optimizes the investment portfolio of a pension or endowment fund, the unusual behavior of a given institutional fund manager should not be called “irrational,” only because the optimal currency hedging level deviates from the one derived under rational expectations. This only justifies the use of different hedging strategies by various institutional investors. We describe in detail how the level of hedging should be revised downwards because of behavioral factors. Conclusions are in the context of what people would predict to see in the market, if certain investors behave in an “irrational” way.     

DO FOREIGN INVESTORS PRICE FOREIGN EXCHANGE RISK DIFFERENTLY?

We test whether foreign investors price foreign exchange risk differently from local investors. Drawing from the closed‐end country fund literature, we argue that both differential access to information by foreign versus local investors and different sources of exchange risk that investors face (economic or translation exposure) will lead to different pricing of the exchange risk associated with American Depositary Receipt (ADR) investments. We apply a two‐step method to country portfolios of ADRs of Australia, France, Japan, and the United Kingdom traded on the New York Stock Exchange. Our results show that foreign investors generally price exchange risk differently from local investors, and that the source and magnitude of differences in exchange risk pricing vary significantly across countries. Although significant differences in pricing exchange risk between foreign and local investors are observed for Australia, France, and Japan, no such pricing difference is noticed for the United Kingdom. Furthermore, the pricing differences observed for Australian and French ADRs are mainly attributed to the exchange risk of underlying share returns (economic exposure), whereas the pricing differences for Japanese ADRs are mainly attributed to the exchange risk associated with currency translation (translation exposure). We offer some explanations for our findings.     

Foreign investment with inflation-linked securities: A natural hedge under Fisher theory?

All foreign holders of U.S. dollars currencies face significant risk of unfavorable currency exchange movements, proportional to the amounts they hold. Some of these risks can be hedged to an extent, but the costs of doing so can be significant, and errors in execution or maintenance of the hedges can cause serious capital losses. Today the vast holdings of China and others creates currency risk on an unprecedented scale. China alone now has a total in excess of a trillion (1 × 10¹²) U.S. dollars, which makes traditional approaches to hedging problematic at best.¹ This paper analyzes the potential hedging effectiveness of investing foreign dollar holdings in U.S. inflation-indexed securities under Fisher's Identity. To the extent that Fisher's Identity and its derivative theories hold, foreign investors can effectively protect the purchasing power of their dollar balances, and earn an assured rate of return. Investment in inflation-indexed securities does not incur the additional expenses that swaps and currency hedges do.     

Bond Risk Premia and The Exchange Rate

In emerging market economies, currency appreciation goes hand in hand with compressed sovereign bond spreads, even for local currency sovereign bonds. This yield compression comes from a reduction in the credit risk premium. Crucially, the relevant exchange rate involved in yield compression is the bilateral U.S. dollar exchange rate, not the trade-weighted exchange rate. Our findings highlight endogenous co-movement of bond risk premia and exchange rates through the portfolio choice of global investors who evaluate returns in dollar terms.     

Exchange rate exposure and foreign exchange derivatives: do ineffective hedgers modify future derivatives use?

Recent studies examining the relationship between stock returns and exchange rate changes have provided evidence that the exchange rate exposure of non-financial companies is reduced by the use of foreign exchange derivatives. Building on such research, this study investigates whether past ineffective derivative hedging contributes to explaining future derivatives use. To the extent that companies monitor the effectiveness of their currency risk management practices, past ineffective hedgers can be expected to modify their future use of foreign exchange derivatives accordingly. In our study of 94 non-financial US multinationals, we provide evidence that the change in derivatives use from 1996–1998 to 1998–2000 can be explained in part by the ineffective hedging of currency risk in 1996–1998, controlling for variables associated with theories of optimal hedging. Additional analyses confirm that such primary results are robust to firm size, the level of foreign operations, and the use of derivatives to partially hedge currency risk. Our results imply that as exchange markets and risk management practices change, the use of derivatives to manage exchange rate risk also changes. Our contribution to this field of study is that we find evidence that past ineffective hedgers tend to increase their future use of FXDs.     

Stochastic risk premiums,stochastic skewness in currency options,and stochastic discount factors in international economies

We develop models of stochastic discount factors in international economies that produce stochastic risk premiums and stochastic skewness in currency options. We estimate the models using time-series returns and option prices on three currency pairs that form a triangular relation. Estimation shows that the average risk premium in Japan is larger than that in the US or the UK, the global risk premium is more persistent and volatile than the country-specific risk premiums, and investors respond differently to different shocks. We also identify high-frequency jumps in each economy but find that only downside jumps are priced. Finally, our analysis shows that the risk premiums are economically compatible with movements in stock and bond market fundamentals.     

Speculative attacks in a two-peg model

We present a two-country model of speculative attacks where the two countries peg their currency to the U.S. dollar and a continuum of investors can either attack or defend one or the two pegs. The main objective of the paper is to show how extending a single-peg model of speculative attacks with the presence of a second country pegging its currency changes the range of parameters for which a currency is attacked. The model suggests that the presence of another country fixing its exchange rate changes dramatically the range of parameters for which a currency is attacked or defended. For example, the model indicates that a peg with a relatively high probability of collapse could survive if the other peg is not very likely to be abandoned, so investors prefer instead to defend the second peg. Finally, under complete information, when the level of fundamentals in both economies is neither weak nor strong the stronger peg may collapse while the weaker peg may survive, so in principle any peg could be successfully attacked.