The effectiveness of position limits: Evidence from the foreign exchange futures markets

This study considers the effects of the relative size of hedger and speculator open interests and the potential impact of implementing position limits on the price discovery process in both JPY–USD and EUR–USD futures markets. Hedging trading exerts a negative impact, regardless of its size, on price discovery in futures markets. Hedgers are less likely to be information motivated, so their trading uniformly delays the price discovery process. However, there is a positive and nonlinear impact of speculators’ trade size on price discovery, the contribution of which depends on the relative size of the speculative open interest. Contrary to conventional wisdom among regulators, speculative trading does not harm the market in terms of market efficiency; as long as the percentage of speculators’ open interest is below an endogenously determined threshold (approximately 20% for EUR–USD and 16.3% for JPY–USD), speculative trading even improves futures market efficiency.     

Interpreting deviations from covered interest parity during the financial market turmoil of 2007–08

This paper investigates the spillover effects of money market turbulence in 2007–08 on the short-term covered interest parity (CIP) condition between the US dollar and the euro through the foreign exchange (FX) swap market. Sharp and persistent deviations from the CIP condition observed during the turmoil are found to be significantly associated with differences in the counterparty risk between European and US financial institutions. Furthermore, evidence is found that US dollar term funding auctions by the ECB, supported by US dollar swap lines with the Federal Reserve, alleviated the level of dislocations, as well as the instability, of the FX swap market.     

Can Markov switching models predict excess foreign exchange returns?

This paper merges the literature on technical trading rules with the literature on Markov switching to develop economically useful trading rules. The Markov models’ out-of-sample, excess returns modestly exceed those of standard technical rules and are profitable over the most recent subsample. A portfolio of Markov and standard technical rules outperforms either set individually, on a risk-adjusted basis. The Markov rules’ high excess returns contrast with mixed performance on statistical tests of forecast accuracy. There is no clear source for the trends, but permitting the mean to depend on higher moments of the exchange rate distribution modestly increases returns.     

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.     

Investment intensity of currencies and the random walk hypothesis: Cross-currency evidence

This paper studies the cross-currency and temporal variations in the random walk behavior in exchange rates. We characterize currencies with relatively large investment flows as investment intensive and conjecture that the more investment intensive a currency is, the closer its exchange rate adheres to random walk. Using 29 floating bilateral USD exchange rates, we find that the higher the investment intensity, the less likely it is to reject random walk and the smaller the deviation from random walk is. However, the effect of investment intensity is non-monotonic. Application of threshold models shows that after investment intensity reaches the estimated thresholds, the level of investment intensity has no further effect on the deviation from random walk. These findings help reconcile the previous conflicting results on the random walk in exchange rates by focusing on the effect of cross-currency and temporal variations in investment intensity.     

News announcements and price discovery in foreign exchange spot and futures markets

This paper studies competition in price discovery between spot and futures rates for the EUR–USD and JPY–USD markets around scheduled macroeconomic announcements. Using both the information shares approach and the common factor component weight approach for futures prices from the Chicago Mercantile Exchange (CME), as well as deal prices from spot trading on the Electronic Broking Services (EBS), we gauge how foreign exchange spot and futures markets respond to news surprises. The results show that the spot rates provide more price discovery than do the CME futures rates overall; however, the contribution of the futures rates to price discovery increases in the time surrounding macroeconomic announcement releases.     

Investigating sources of unanticipated exposure in industry stock returns

This paper investigates the sources of both foreign exchange rate and interest rate exposure of industry level portfolios in the G7, decomposing exposure into cash flow and discount rate effects. Initial examination of the degree of exposure on industry returns produces results consistent with the prior literature: that there is little evidence of exchange rate exposure in most industries - the exchange rate exposure puzzle. However, rather than relying solely on the sensitivity of industry returns, we examine the cash flow sensitivity to foreign exchange exposure, of primary interest to firm managers. Critically, decomposing the exposure into cash flow and discount rate components unlocks the exact extent and nature of exposure. Our results show industries have significant cash flow and discount rate exposures. These exposures increase with the level of trade openness and the spread between permanent cash flow exposure and transitory discount rate exposure widens.     

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.     

Smiles all around: FX joint calibration in a multi-Heston model

We introduce a novel multi-factor Heston-based stochastic volatility model, which is able to reproduce consistently typical multi-dimensional FX vanilla markets, while retaining the (semi)-analytical tractability typical of affine models and relying on a reasonable number of parameters. A successful joint calibration to real market data is presented together with various in- and out-of-sample calibration exercises to highlight the robustness of the parameters estimation. The proposed model preserves the natural inversion and triangulation symmetries of FX spot rates and its functional form, irrespective of choice of the risk-free currency. That is, all currencies are treated in the same way.     

Gold and the Dollar (and the Euro, Pound, and Yen)

Usually, gold and the Dollar are negatively related; when the Dollar price of gold increases, the Dollar depreciates against other currencies. This is intuitively puzzling because it seems to suggest that gold prices are associated with appreciation in other currencies. Why should the Dollar be different? We show here that there is actually no puzzle. The price of gold can be associated with currency depreciation in every country. The Dollar price of gold can be related to Dollar depreciation and the Euro (Pound, Yen) price of gold can be related to Euro (Pound, Yen) depreciation. Indeed, this is usually the case empirically.     

Crash-neutral currency carry trades

Currency carry trades exploiting violations of uncovered interest rate parity in G10 currencies deliver significant excess returns with annualized Sharpe ratios equal to or greater than those of equity market factors (1990–2012). Using data on out-of-the-money foreign exchange options, I compute returns to crash-hedged portfolios and demonstrate that the high returns to carry trades are not due to peso problems. A comparison of the returns to hedged and unhedged trades indicates crash risk premia account for at most one-third of the excess return to currency carry trades.     

Foreign exchange market reactions to sovereign credit news

We analyse the reaction of the foreign exchange spot market to sovereign credit signals by Fitch, Moody’s and S&P during 1994–2010. We find that positive and negative credit news affects both the own-country exchange rate and other countries’ exchange rates. We provide evidence on unequal responses to the three agencies’ signals. Fitch signals induce the most timely market responses, and the market also reacts strongly to S&P negative outlook signals. Credit outlook and watch actions and multiple notch rating changes have more impact than one-notch rating changes. Considerable differences in the market reactions to sovereign credit events are highlighted in emerging versus developed economies, and in various geographical regions.     

Foreign exchange market efficiency under recent crises: Asia-Pacific focus

The Asia-Pacific region’s currency markets are generally efficient within-country when tested using the 30 and 31 cointegration technique whereas market efficiency fails to hold when tested using Fama’s (1984) conventional regression. Using the Pilbeam and Olmo (2011) model, we reconcile these conflicting findings. The Pilbeam and Olmo (2011) model confirms within-country market efficiency. It further confirms that free-float currency markets are more resilient than managed-float currency markets among 12 Asia-Pacific economies. From the across-country perspective, the foreign exchange markets are mostly efficient and the results show that the 1997–1998 Asian financial crisis was a more disturbing event than the 2008–2009 global financial crisis in the region.     

Day-of-the-week effect in the Taiwan foreign exchange market

This study uses stochastic dominance with and without risk-free assets to examine whether trading days can affect patterns of the day-of-the-week effect in the Taiwan foreign exchange market. Our results generally indicate that higher returns appear on the first three days of the week across different trading-day regimes in the Taiwan foreign exchange market, confirming day-of-the-week effect. Allocating part of investors’ assets in risk-free assets is useful in distinguishing returns among weekdays for all currencies.     

Portfolio reallocation and exchange rate dynamics

This paper explains exchange rate dynamics by linking financial customers’ foreign exchange order flow with their dynamic portfolio reallocation. For any currency pair in a particular period, one currency has higher assets return than the other and can be considered the high-return-currency (HRC). Financial institutions attempt to hold more HRC assets when they become more risk-loving or the relative return of the assets is expected to increase. Such a portfolio reallocation generates buy order toward the HRC and the currency appreciates. As the HRC changes over time, the direction that the relative return and risk appetite affect the exchange rate varies in different regimes.     

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.