Who times the foreign exchange market? Corporate speculation and CEO characteristics

This paper shows that managers' personal beliefs and individual characteristics explain a large share of the substantial time-variation of derivative use beyond firm, industry, and market fundamentals. We construct a panel data set of foreign currency derivative holdings and currency exposures for U.S. non-financial firms. We use a novel approach to build a firm-specific foreign exchange return. We find that managers adjust derivatives notional amounts in response to past foreign exchange returns, as if they were forming views on future currency prices. We then construct an empirical measure of speculative behavior for each firm to investigate the profile of the speculator. Firms where the CEO holds an MBA degree, is younger, and has less previous working experience speculate more. These results are consistent with overconfident managers taking more risk.     

What drives volatility persistence in the foreign exchange market?

We propose a new empirical specification of volatility that links volatility to the information flow, measured as the order flow in the market, and to the price sensitivity to that information. The time-varying market sensitivity to information is estimated from high-frequency data, and movements in volatility can therefore be directly related to movements in order flow and market sensitivity. Empirically, the model explains a large share of the long-run variation in volatility. Importantly, the time variation in the market's sensitivity to information is at least as relevant in explaining the persistence of volatility as the rate of information arrival itself. This may be evidence of a link between changes over time in the aggregate behavior of market participants and the time-series properties of realized volatility.     

Are capital controls in the foreign exchange market effective?

One of the reasons for governments to employ capital controls is to obtain some degree of monetary independence. In this paper we test whether capital controls can reduce the link between exchange rates fluctuations and cross border interest differentials. Recent capital control proxies are used in order to determine the date of capital account liberalization for a panel of Western European and emerging countries. Results show that capital controls have a very limited effect on observed deviations from interest parities, even when accounting for the political risk associated with capital controls.     

A note on the time–series relationship between market industry concentration and market volatility

Using cross-sectional regression analysis, previous studies provide conflicting results regarding the relationship between market industry concentration and market volatility. This paper investigates this relationship in the time–series. Using data from twenty one developed markets and the world market, we find that this relationship is significant and positive in about 61% of the markets: the more concentrated the market, the more volatile the market. We also find that, in 70% of the markets, there exists a causal relationship between market industry concentration and market volatility and the direction of causality runs from the former to the latter. Our results suggest that market industrial structure is a significant factor in explaining market volatility.     

Investors’ heterogeneous beliefs and the impact of sovereign credit ratings in foreign exchange and equity markets

We propose a model in which sovereign credit news from multiple rating agencies interacts with market heterogeneity. The model illustrates that the first messenger discloses new information while additional messengers play an important role of coordinating heterogeneous beliefs. Empirical investigations based on sovereign credit ratings, foreign exchange and equity markets confirm that rating news coordinates investors’ beliefs. Sovereign credit rating news from both types of messenger induces a significant impact on exchange rates and stock indices. Volatility measures increase in response to news from the first messenger while ex-post volatility reduces following news from an additional messenger.     

Time-varying risk premia in foreign exchange and equity markets: evidence from Asia–Pacific countries

This paper examines the validity of the risk premia hypothesis in explaining deviations from Uncovered Interest Parity (UIP) and the role of deviations from Purchasing Power Parity (PPP) in the pricing of foreign exchange rates and equity securities in five Asia–Pacific countries and the US. Using weekly data from 1 January, 1988 to 27 February, 1998, I find that conditional variances are not related to the deviations from UIP in any statistical sense based on an univariate GARCH(1,1)-M model. As I consider both foreign exchange and equity markets together and test a conditional international CAPM (ICAPM) in the absence of PPP, I cannot reject the model based on the J-test by Hansen (Econometrica 50 (1982), 1029–1054) and find significant time-varying foreign exchange risk premia present in the data. This empirical evidence supports the notion of time-varying risk premia in explaining the deviations from UIP. It also supports the idea that the foreign exchange risk is not diversifiable and hence should be priced in both markets.     

Short-term market timing using the bond–equity yield ratio

This paper takes a new look at the market-timing ability of the bond–equity yield ratio (BEYR). We compare the short-term profitability of a naive strategy based on the extreme values of the BEYR to the short-term profitability of a sophisticated strategy relying on regime switches. In contrast to previous studies, we do not document any major international evidence that these dynamic strategies deliver significantly higher risk-adjusted returns than the buy-and-hold portfolios. Moreover, the profitability of these active strategies is not improved when the equity yield, instead of the BEYR, is used as a criterion to time the market.     

Can technical trading beat the foreign exchange market in times of crisis?

I examine the profitability of three simple foreign exchange technical trading rules (moving average, momentum, and relative strength index) before, during, and after the 2007–2008 global financial crisis. These rules significantly improve profitability during the crisis (as opposed to before and after it). The moving average rule significantly increases profitability for exchange rate changes during the crisis. The momentum and relative strength index rules generate significant positive excess currency returns (defined as the difference between the forward premium and spot rate changes), but this profitability is not visible in spot rate changes. These findings are robust for portfolios of developed and emerging market currencies as well as for bilateral exchange rates.     

Can Markov switching models replicate chartist profits in the foreign exchange market?

In this paper we show that the Markov switching model is a relevant statistical alternative to the classical martingale model for exchange rates. By extending the standard Markov switching model we decisively reject the martingale model. Moreover, the model generates autocorrelations and linear structures in line with what is observed in reality. Subsequently, we test whether this model can explain chartist profits. We find that the extended Markov switching model is able to explain the profitability of a simple MA-30 rule. Finally, we decompose the profitability of the MA-30 rule into a linear and nonlinear part. We find that, although the implied linear structure of the Markov model explains a substantial part of the profitability, part of the profits of the MA-30 rule can be attributed to the specific nonlinearities implicit in the Markov model.     

Is the foreign exchange market ‘risky’? Some new survey-based results

In this paper we examine the evidence in favour of time-varying risk premia for four foreign exchange markets. The main novelty in our work is that we use survey-based expectations data to generate risk premia, rather than exploiting the rational expectations assumption. In contrast to the perceived wisdom on the existence of a foreign exchange risk premium, we present positive evidence for the view that risk is an important variable in foreign exchange markets.     

The market price of risk and the equity premium: A legacy of the Great Depression?

By positing learning and a pessimistic initial prior, we build a model that disconnects a representative consumer's subjective attitudes toward risk from the high price of risk that a rational-expectations econometrician would deduce from financial market data. We follow Friedman and Schwartz [1963. A Monetary History of the United States, 1857-1960. Princeton University Press, Princeton, NJ] in hypothesizing that the Great Depression heightened fears of economic instability. We use a robustness calculation to elicit a pessimistic prior for a representative consumer and let him update beliefs via Bayes’ law. Learning eventually erases pessimism, but while it persists, pessimism contributes a volatile multiplicative component to the stochastic discount factor that a rational-expectation econometrician would detect. With sufficient initial pessimism, the model generates substantial values for the market price of risk and equity premium and predicts high Sharpe ratios and forecastable excess stock returns.     

The relationship between size,book-to-market equity ratio,earnings–price ratio,and return for the Hong Kong stock market

In this paper, we investigate the relation between stock returns and β, size (ME), leverage, book-to-market equity ratio, and earnings–price ratio (E/P) in Hong Kong stock market using the Fama and French (FF) [J. Finance 47 (1992) 427] approach. FF find that two variables, size and book-to-market equity, combine to capture the cross-sectional variation in average stock returns associated with β, size, leverage, book-to-market equity, and E/P ratios. In this paper, similar to previous studies in Hong Kong and US stock markets, we find that β is unable to explain the average monthly returns on stocks continuously listed in Hong Kong Stock Exchange for the period July 1984–June 1997. But three of the variables, size, book-to-market equity, and E/P ratios, seem able to capture the cross-sectional variation in average monthly returns over the period. The other two variables, book leverage and market, are also able to capture the cross-sectional variation in average monthly returns. But their effects seem to be dominated by size, book-to-market equity, and E/P ratios, and considered to be redundant in explaining average returns when size, book-to-market equity, and E/P ratios are also considered. The results are consistent across subperiods, across months, and across size groups. These suggest that the results are not driven by extreme observations or abnormal return behavior in some of the months or by size groups.     

Global financial crisis and emerging stock market contagion: A multivariate FIAPARCH–DCC approach

This paper empirically investigates the contagion effects of the global financial crisis in a multivariate Fractionally Integrated Asymmetric Power ARCH (FIAPARCH) dynamic conditional correlation (DCC) framework during the period 1997–2012. We focus on five most important emerging equity markets, namely Brazil, Russia, India, China and South Africa (BRICS), as well as USA during different phases of the crisis. The length and the phases of the crisis are identified based on both an economic and a statistical approach. The empirical evidence does not confirm a contagion effect for most BRICS during the early stages of the crisis, indicating signs of isolation or decoupling. However, linkages reemerged (recoupled) after the Lehman Brothers collapse, suggesting a shift on investors' risk appetite. Moreover, correlations among all BRICS and USA are increased from early 2009 onwards, implying that their dependence is larger in bullish than in bearish markets. These findings do not show a pattern of contagion for all BRICSs' markets that could be attributed to their common trade and financial characteristics and provide important implications for international investors and policymakers.     

Flight-to-quality in the stock–bond return relation: a regime-switching copula approach

Financial Markets and Portfolio Management - This paper examines the existence, intensity and international dependence of flight-to-quality from stocks to government bonds. To this end, we develop...     

Is the relationship between prices and exchange rates homogeneous?

Empirical tests of purchasing power parity (PPP) are implicitly based on the conditions of symmetry and proportionality of the price coefficients. We investigate a separate condition, which we term homogeneity. Specifically, while there may be factors that drive a wedge between prices and exchange rates, when these factors are held constant we would expect a change in exchange rates to be associated with a proportional, or homogeneous, change in prices. To test for the existence of homogeneity in prices, we conduct two experiments. First, we apply a time-varying-coefficient procedure to nine euro-area countries as well as the euro area as a whole during the (monthly) sample period, 1999:M1 to 2011:M3. Second we apply the same procedure to the same group of countries, plus Canada, Japan and Mexico, over the longer period, 1957:M4 to 2011:M3. We find that averages of the price coefficients, corrected for specification biases, are uniformly homogeneous in the long run, providing strong support for PPP.     

Does the stock market fully value intangibles? Employee satisfaction and equity prices

This paper analyzes the relationship between employee satisfaction and long-run stock returns. A value-weighted portfolio of the “100 Best Companies to Work For in America” earned an annual four-factor alpha of 3.5% from 1984 to 2009, and 2.1% above industry benchmarks. The results are robust to controls for firm characteristics, different weighting methodologies, and the removal of outliers. The Best Companies also exhibited significantly more positive earnings surprises and announcement returns. These findings have three main implications. First, consistent with human capital-centered theories of the firm, employee satisfaction is positively correlated with shareholder returns and need not represent managerial slack. Second, the stock market does not fully value intangibles, even when independently verified by a highly public survey on large firms. Third, certain socially responsible investing (SRI) screens may improve investment returns.     

The long memory of the forward premium during the 1920s’ float: evidence from the European foreign exchange market

This paper investigates the fractional dynamics of the foreign exchange forward premium during the floating period of the 1920s. We apply weekly exchange rates of the currencies from Belgium, France, Germany, Holland, Italy and the USA against the British pound from February 1921 to May 1925 and employ two different definitions of the forward premium. The German data are for the period ranging from February 1921 to December 1922. This period includes the German hyperinflation era. The empirical investigation is conducted by means of two different fractional integration methods: the Geweke and Porter-Hudak and the Robinson tests. The results provide some evidence of long memory, mostly in the case of Belgium, Holland and Italy. Many of the forward premiums during the 1920s may have become non-stationary as markets began to anticipate the UK's return to gold at its pre-war parity. In the case of Germany, it may have been due to market failure. The varying results presented could be due to the wide differences in the microeconomic and macroeconomic fundamentals and political setups of the countries during the 1920s.     

Relative equity market valuation conditions and acquirers’ gains

We examine whether the relative equity market valuation conditions (EMVCs) in the countries of merging firms help acquirers’ managers to time the announcements of both domestic and foreign targets. After controlling for several deal- and merging firm-specific features we find that the number of acquisitions and acquirers’ gains are higher during periods of high-EMVCs at home, irrespective of the domicile of the target. We also find that the higher gains of foreign target acquisitions realized during periods of high-EMVCs at home stem from acquiring targets based in the RoW (=World-G7), rather than the G6 (=G7-UK) group of countries. We argue that this is due to the low correlation of EMVCs between the UK (home) and the RoW group of countries. However, these gains disappear or even reverse during the post-announcement period. Moreover, acquisitions of targets domiciled in the RoW (G6) countries yield higher (lower) gains than acquisitions of domestic targets during periods of high-EMVCs at home. This suggests that the relative EMVCs between the merging firms’ countries allow acquirers’ managers to time the market and acquire targets at a discount, particularly in countries in which acquirers’ stocks are likely to be more overvalued than the targets’ stocks.     

The volume–volatility relationship and the opening of the Korean stock market to foreign investors after the financial turmoil in 1997

This paper investigates the stock volatility–volume relation in the Korean market for the period 1995–2001. Previous research examined the impact of liberalization on the Korean stock market up to the period before the financial turmoil in 1997 although the crucial measures of the liberalization were introduced after the crisis under the International Monetary Fund program. One of the major features of the reformation was the financial opening to foreign investors. In this study the ‘total’ trading volume is separated into the domestic investors’ and the foreign investors’ volume. By doing this the information used by two different groups of traders can be separated. Further, in addition to the absolute value of the returns and their squares we use the conditional volatility from a GARCH-type model as an alternative measure of stock volatility. The following observations, among other things, are noted about the volume–volatility causal relationship. First, for the entire period there is a strong bidirectional feedback between volume and volatility. In most cases this causal relationship is robust to the measures of volume and volatility used. Second, volatility is related only to ‘domestic’ volume before the crisis whereas after the crisis a bidirectional feedback relation between ‘foreign’ volume and volatility begins to exist. In other words, ‘foreign’ volume tends to have more information about volatility in recent years, which suggests the increased importance of ‘foreign’ volume as an information variable.      

Investor sentiment and the risk–return relation: A two-in-one approach

Traditional finance theory posits a positive risk–return relation, but empirical evidence is inconclusive. Retail investor sentiment has long been viewed as a distorting factor, while more recently institutional investor sentiment is thought to play a role. We examine the separate and joint impacts of retail and institutional investor sentiments on the risk-return relation. We find, at both market and firm levels, the risk-return relation is more likely to be distorted by the two investor-type sentiments jointly, rather than separately. We further find a cross-sectional pattern, with the risk-return relation being more sensitive to investor sentiment for stocks with specific characteristics.