Exchange risk and universal returns: A test of international arbitrage pricing theory

According to the international arbitrage pricing theory (IAPT) posited by Solnik (1983), currency movements affect assets' factor loadings and associated risk premiums. Based on a novel universal return decomposition, we propose an empirical model to test this proposition and perform tests using U.S. stock returns in the period 1975–2008. Our results confirm that currency movements significantly affect the market betas of a large proportion of stocks. Further cross-sectional tests indicate that currency movements affecting the market factor are significantly priced in stock returns. Based on these and other findings, we conclude that Solnik's IAPT is supported. An important implication of our findings is that exchange rate risk can broadly affect stock returns through both factor loading and residual factor channels.     

The ‘laissez faire’ bias of managed floating

The government of a small open economy trying to manage its exchange rate faces a ‘time consistency’ problem. If markets expect implementation of the optimal linear intervention rule, the government will be tempted to ‘defect’: knowing this, markets will expect less activism; and, in the discretionary equilibrium, this is what they get. How far this credibility problem can shift discretionary policy towards a free float is shown in two popular models of floating rates. One way of offsetting the ‘laissez faire’ bias of discretionary policy is to appoint a relatively ‘conservative’ central banker: but, as the time period of policy action and precommitment shrinks towards zero, the required conservative bias is found to go towards infinity. Other institutional features — such as central bank reputation, contracts and intermediate targets — may be crucial for successful exchange rate management.     

Managerial compensation and the debt placement decision

Extant research argues that borrowing from financial intermediaries subjects managers to external monitoring. However, given managers' flexibility in choosing the type of debt financing, why would managers submit themselves to external monitoring? Recent theory points to the role of managerial incentive compensation. Specifically, it is argued that managers will borrow from financial intermediaries if their compensation is tied to firm performance. Additionally, it is noted that a more optimal compensation scheme will induce managers to undertake intermediated loans only when the firm is sufficiently profitable. Such a compensation scheme is likely to exist in opaque firm settings where borrowing from financial intermediaries can serve to signal firm profitability. Our study provides corroborative evidence. We find that the choice of syndicated bank loans is positively associated with CEO equity incentives. Second, this syndicated debt-incentive compensation link is influenced by firm profitability, particularly among information problematic firms. Overall, our study points to the role of incentive compensation in the debt placement decision.     

Explaining exchange rate volatility: an empirical analysis of ‘the holy trinity’ of monetary independence, fixed exchange rates, and capital mobility

This paper uses a panel of data from twenty-two countries between 1967 and 1992 to explain exchange rate volatility, focusing on potential tradeoffs between fixed exchange rates, independent monetary policy, and capital mobility. I use monetary models to parameterize monetary divergence and factor analysis to measure capital mobility. Exchange rate volatility is loosely linked to both monetary divergence and the degree of capital mobility. Interestingly, exchange rate volatility is significantly correlated with the width of the explicitly declared exchange rate band, even after taking monetary divergence and capital mobility into account.     

Current account imbalances and financial integration in the euro area

While the current account of the euro area as a whole has remained almost balanced in the past two decades, several member countries have sizeable deficits or surpluses. In this paper, we interpret these imbalances as indicators of net capital flows among the euro-area countries. We distinguish between balances against the euro zone and the rest of the world and examine these for the EU-15 countries. We find that for euro members the net flows follow differences in per-capita incomes, even before the introduction of the euro. Our results show further that with the introduction of the common currency the elasticity with respect to per-capita incomes of net capital flows within the euro area has increased for the members of the euro zone. This increase can neither be observed for the flows between the euro members and the rest of the world nor for the flows between the countries that stayed outside the monetary union and the euro zone. We interpret this as evidence for increasing financial integration in the euro area. There is also some evidence suggesting that the introduction of the euro has led to some financial diversion.     

On the relationship between exchange rates and equity returns: A new approach

This paper employs a new approach in order to investigate the underlying relationship between stock markets and exchange rates. Current approaches suggest that the relative equity market performance of two countries is linked to their exchange rate. In contrast, this study proposes an alternative approach where one global variable – global equity market returns – is believed to have an effect on exchange rates, with the relative interest rate level of a currency determining the sign of the relationship. Our empirical findings suggest that exchange rates and global stock market returns are strongly linked. The value of currencies with higher interest rates is positively related with global equity returns, whereas the value of currencies with lower interest rates is negatively related with global equity returns.     

Calculating the equity cost of capital using the APT: the impact of the ERM

One of the expected benefits of membership of the Exchange Rate Mechanism (ERM) was a reduction in risk which should lead to a lower cost of capital and foster investment and growth. Using the APT, we investigate the behavior of the equity market risk premium for the London Stock Exchange prior to and during sterling's membership of the ERM. We find that prior to and during the first year of membership the equity market risk premium fell quite dramatically. However, when conflict between domestic and ERM policy requirements arose at the turn of 1991, the equity risk premium increased and continued to do so until sterling's exit, partially wiping out the benefits of membership of the ERM.     

Forward exchange market unbiasedness: the case of the Australian dollar since 1984

This paper implements a robust statistical approach to regression with non-stationary time series. The methods were recently developed in other work and are briefly exposited here. They allow us to perform regressions in levels with non-stationary time series data, they accommodate data distributions with heavy tails and they permit serial dependence and temporal heterogeneity of unknown form in the equation errors. With these features the methods are well suited to applications with frequently sampled exchange rate data, which generally display all of these empirical characteristics. Our application here is to daily data on spot and forward exchange rates between the Australian and US dollars over the period 1984–1991, following the deregulation of the Australian foreign exchange market. We find big differences between the robust and the non-robust regression outcomes and in the associated statistical tests of the hypothesis that the forward rate is an unbiased predictor of the future spot rate. The robust tests reject the unbiasedness hypothesis but still give the forward rate an important role as a predictor of the future spot rate.     

A comment on: “The solution to the forward-bias puzzle”

Pippenger (2011) recently proposed a solution to the longstanding forward-bias puzzle. He argues that the puzzling estimates obtained using the standard equation for the efficient markets hypothesis are due to omitted variable bias. He identifies the missing variables as the future change in the forward exchange rate and the future interest differential. When these are added to the standard equation, he finds a one-to-one relationship between the future change in the spot rate and the forward premium. However, we argue that his equation can only test covered interest parity and offers no insight into the forward-bias puzzle.     

Family control and investment–cash flow sensitivity: Empirical evidence from the Euro zone

This paper considers the ownership structure of family firms to determine whether family control alleviates or exacerbates investment–cash flow sensitivity in the Euro zone. We find that family-controlled corporations have lower investment–cash flow sensitivities. Further, our results show that this reduced sensitivity is mainly attributable to family firms with no deviations between cash flow and voting rights and to family firms in which family members hold managerial positions. We also find that second largest shareholders affect family firms' sensitivity and are associated with either monitoring (non-family second blockholders) or collusion (family second blockholders). Overall, family control seems to mitigate investment inefficiencies that derive from capital market imperfections.     

Burgernomics: the economics of the Big Mac standard

In the course of PPP research, much of the debate over the validity has been over the choice of an appropriate ‘basket’ for making purchasing power comparisons. The different compositions of goods and services in these baskets across countries have resulted in arguments against their usefulness for PPP purposes. This problem is augmented by the existence of productivity differentials in traded and non-traded goods across countries. Therefore we consider the use of the Big Mac as the international monetary standard as being a more palatable alternative: It is produced locally in over 80 countries around the world, with only minor changes in recipe and thus has the flavour of ‘the perfect universal commodity’. Our results indicate that the Big Mac Index is surprisingly accurate in tracking exchange rates over the long-term, which is consistent with previous PPP research findings. We subsequently enhance our PPP comparisons by taking into account the productivity differentials between countries and excluding non-traded goods from the Big Mac Index to derive the No-Frills Index.     

Does FOMC news increase global FX trading?

Does global currency volume increase on Federal Open Market Committee (FOMC) days? To test hypotheses of abnormal currency volume on FOMC days, a new data set from the Continuous Linked Settlement (CLS) Bank is used. The CLS measure captures more than half of the global trading volume in foreign exchange (FX) markets. The evidence shows that FX trading volume increases about 5% in the spot and the spot-next market following FOMC deliberations. The novelty of this result is that the aggregated CLS data controls for responses in various derivatives markets: a feature that existing studies based on intradaily data for specific trading platforms do not consider.     

Intertemporal risk-return trade-off in foreign exchange rates

We investigate the intertemporal risk-return trade-off of foreign exchange (FX) rates for ten currencies quoted against the USD. For each currency, we use three risk measures simultaneously that pertain to that currency; its realized volatility, its realized skewness, and its value-at-risk. We apply monthly FX excess returns and risk measures calculated from daily observations. We find that there is a significant contemporaneous risk-return trade-off for the currencies under investigation. There is no evidence of noncontemporaneous risk-return trade-off. We pay special attention to the risk-return trade-off during the recent financial crisis.     

What UIP tests on extreme samples reveal about the missing variable

In their UIP regressions, Huisman et al. (1998. Extreme support for uncovered interest parity, Journal for International Money and Finance 17, 211–228.) focus on extreme forward premia and find much higher coefficients. We show that, for such results, the expectation signal needs to be thicker-tailed than the missing variable. Transaction costs may produce the right sort of bias. It is (i) bounded (i.e. it has no tails at all), (ii) wide (i.e. it may generate betas below 1/2) and (iii) U-distributed, which makes an “extreme” sample quite effective. We derive theoretical and numerical results in the direction of what Huisman et al. observe. We also tighten Fama's moment conditions.     

Price discovery in currency markets

This paper examines the price discovery process in currency markets, basing its analysis on the pivotal distinction between the customer (end-user) market and the interdealer market. It first provides evidence that this price discovery process cannot be based on adverse selection between dealers and their customers, as postulated in standard models, because the spreads dealers quote to their customers are not positively related to a trade’s likely information content. The paper then highlights three factors familiar in the literature – fixed operating costs, market power, and strategic dealing – that may explain the cross-sectional variation in customers’ spreads. The paper finishes by proposing a price discovery process relevant to liquid two-tier markets and providing preliminary evidence that this process applies to currencies.     

Microstructural dynamics in a foreign exchange electronic broking system

This paper explores the relationships between quotations, spreads and transactions in the Foreign Exchange market. Such interactions have been the subject of much work in markets such as the NYSE, but until now have gone unexamined in the FX market owing to a lack of data. Using a 7 hour, transactions-based data set we examine the determinants of both quote revisions and spreads. The results indicate that trades are a major factor in spread determination and quote revisions. Furthermore, there is evidence that the widely documented negative auto-correlation in quote returns is at least partially caused by the ‘thinness’ of this particular segment of the FX market.     

The genesis of the 2008 global financial crisis and challenges to the neoclassical paradigm of finance

In the first step, this paper briefly discusses the macroeconomic background of the 2008 financial crisis. Next, we take a wider approach and we look at systemic changes that global economics, and financial markets in particular, had undergone. We wonder if these transformations, and their effects so dramatically demonstrated in 2008, give grounds to modify the theoretical background of finance. The neoclassical paradigm might be seen as an idealized normative benchmark. On the other hand, behavioral approach helps explain deviations from this benchmark, however itself it lacks the normative character. We conclude that in contemporary circumstances an interdisciplinary approach is needed in the search for an adequate theory, as the financial world is getting more and more complex and dynamic.     

Macroeconomic risk and the cross-section of stock returns

We develop a conditional version of the consumption capital asset pricing model (CCAPM) using the conditioning variable from the cointegrating relation among macroeconomic variables (dividend yield, term spread, default spread, and short-term interest rate). Our conditioning variable has a strong power to predict market excess returns in the presence of competing predictive variables. In addition, our conditional CCAPM performs approximately as well as Fama and French’s (1993) three-factor model in explaining the cross-section of the Fama and French 25 size and book-to-market sorted portfolios. Our specification shows that value stocks are riskier than growth stocks in bad times, supporting the risk-based story.     

Exchange rate mean reversion from real shocks within an intertemporal equilibrium model

The post Bretton Woods era has been characterized by real exchange rates that exhibit mean reversion, with mixed evidence as to whether this reversion is partial (PPP never holds) or essentially complete. This paper generates these stylized facts theoretically by synthesizing a simple intertemporal open economy model with the elasticities approach to the current account. A central feature of the model is the existence of non-traded goods. The model can generate partial or approximately complete mean reversion for the real exchange rate (depending on parameter values) if innovations in output are made up of permanent and temporary components. In addition, temporary output shocks generate a type of hysteresis wherein the short-run path for the exchange rate permanently alters its long-run equilibrium value.     

Calibrating an algorithm for estimating transactions from FXFX exchange rate quotes

In this paper we investigate the efficiency of a class of transaction-generating algorithms, originally suggested in Bollerslev and Domowitz (1993). Our comparison utilizes real transaction data recorded over Reuters D2000-2 electronic broking system for 7 h in June 1993 and transaction data generated from FXFX quotations over an identical period. Results suggest that, at this high-frequency data sampling, the performance of these transaction-generating algorithms is poor, with the most likely explanation of this outcome due to the high-frequency characteristics of FXFX spreads and quotation intensity.