Crossing the lines: The conditional relation between exchange rate exposure and stock returns in emerging and developed markets

This paper examines the importance of exchange rate exposure in the return generating process for a large sample of non-financial firms from 37 countries. We argue that the effect of exchange rate exposure on stock returns is conditional and show evidence of a significant return impact to firm-level currency exposures when conditioning on the exchange rate change. We further show that the realized return to exposure is directly related to the size and sign of the exchange rate change, suggesting fluctuations in exchange rates as a source of time-variation in currency return premia. For the entire sample the return impact ranges from 1.2 to 3.3% per unit of currency exposure, and it is larger for firms in emerging markets compared to developed markets. Overall, the results indicate that foreign exchange rate exposure estimates are economically meaningful, despite the fact that individual time-series results are noisy and many exposures are not statistically significant, and that exchange rate exposure plays an important role in generating cross-sectional return variation. Moreover, we show that the relation between exchange rate exposure and stock returns is more consistent with a cash flow effect than a discount rate effect.     

TESTS OF THE BLACK-SCHOLES AND CONSTANT ELASTICITY OF VARIANCE CURRENCY CALL OPTION VALUATION MODELS

An adaptation of the Cox-Ross/Emanuel-MacBeth call option valuation model for constant elasticity of variance diffusion processes is tested here against an adaptation of the Black-Scholes call option valuation model for the pricing of call currency options. Synchronized transactions data supplied by the Philadelphia Exchange are used. A maximum likelihood estimation procedure indicates a significant association between currency return variances and exchange rate levels. The constant elasticity of variance model exhibits significantly superior pricing accuracy for predictive intervals of three or fewer trading days.     

Rate of return parity and currency crises in experimental asset markets

This paper explores the impact of exchange rate uncertainty on the predictive power of rate of return parity in a laboratory environment, extending the work of Fisher and Kelly [Fisher, E.O., Kelly, F.S., 2000. Experimental foreign exchange markets. Pacific Economic Review 5, 365–388] and Childs and Mestelman [Childs, J., Mestelman, S., 2006. Rate of return parity in experimental asset markets. Review of International Economics 14, 331–347]. While these works use unchanging exchange rates, this paper allows for a change in the exchange rate between laboratory currencies. The data indicate rate of return parity is weakened by the potential for a currency crisis. The results also indicate that currency crises can be caused by self-fulfilling prophecies and that the level of reserves with which a fixed exchange rate is defended impacts the timing of a crisis but does not significantly change the likelihood of a currency crisis.     

基于分数维随机利率的分数跳-扩散外汇期权定价

假设利率为分数维随机利率,外汇汇率服从分数跳一扩散过程,并且波动率为常数,期望收益率为时间的非随机函数,本文利用保险精算方法,得出了看涨、看跌外汇欧武期权的一般定价公式,并建立了平价公式。     

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.     

An Asymptotic Expansion Approach to Currency Options with a Market Model of Interest Rates under Stochastic Volatility Processes of Spot Exchange Rates

This paper proposes an asymptotic expansion scheme of currency options with a libor market model of interest rates and stochastic volatility models of spot exchange rates. In particular, we derive closed-form approximation formulas for the density functions of the underlying assets and for pricing currency options based on a third order asymptotic expansion scheme; we do not model a foreign exchange rate’s variance such as in Heston [(1993) The Review of Financial studies, 6, 327–343], but its volatility that follows a general time-inhomogeneous Markovian process. Further, the correlations among all the factors such as domestic and foreign interest rates, a spot foreign exchange rate and its volatility, are allowed. Finally, numerical examples are provided and the pricing formula are applied to the calibration of volatility surfaces in the JPY/USD option market.     

Central bank interventions and implied exchange rate correlations

This paper examines the effects of the foreign exchange market interventions by the Bank of Japan on the ex ante correlations between the JPY/USD, EUR/USD, and GBP/USD exchange rates. The correlation estimates used in the analysis are derived from the market prices of OTC currency options. The results show that central bank interventions significantly affect the market expectations about future exchange rate co-movements. In particular, we find that interventions tend to temporarily increase the ex ante correlations among the major exchange rates. However, our results also suggest that intervention episodes are associated with lower-than-average levels of exchange rate correlations.     

Central bank intervention and the intraday process of price formation in the currency markets

We propose a novel theory of the impact of sterilized spot interventions on the microstructure of currency markets that focuses on their liquidity. We analyze the effectiveness of intervention operations in a model of sequential trading in which i) a rational Central Bank faces a trade-off between policy motives and wealth maximization; ii) currency dealers' sole objective is to provide immediacy at a cost while maintaining a driftless expected foreign currency position; and iii) adverse selection, inventory, signaling, and portfolio balance considerations are absent by assumption. In this setting, and consistent with available empirical evidence, we find that i) the mere likelihood of a future intervention—even if expected, non-secret, and uninformative—is sufficient to generate endogenous effects on exchange rate levels, to increase exchange rate volatility, and to impact bid-ask spreads; and ii) these effects are exacerbated by the intensity of dealership competition, the extent of the Central Bank's policy trade-off, and the credibility of its threat of future actions.     

Equilibrium Valuation of Foreign Exchange Claims

This article studies the equilibrium valuation of foreign exchange contingent claims. Within a continuous-time Lucas (1982) two-country model, exchange rates, interest rates and, in particular, factor risk prices are all endogenously and jointly determined. This guarantees the internal consistency of these price processes with a general equilibrium. In the same model, closed-form valuation formulas are presented for currency options and currency futures options. Common to these formulas is that stochastic volatility and stochastic interest rates are admitted. Hedge ratios and other comparative statics are also provided analytically. It is shown that most existing currency option models are included as special cases.     

The effect of personal taxes and dividends on capital asset prices: Theory and empirical evidence

This paper derives an after tax version of the Capital Asset Pricing Model. The model accounts for a progressive tax scheme and for wealth and income related constraints on borrowing. The equilibrium relationship indicates that before-tax expected rates of return are linearly related to systematic risk and to dividend yield. The sample estimates of the variances of observed betas are used to arrive at maximum likelihood estimators of the coefficients. The results indicate that, unlike prior studies, there is a strong positive relationship between dividend yield and expected return for NYSE stocks. Evidence is also presented for a clientele effect.     

The effectiveness of currency-hedging techniques over multiple return horizons for foreign-denominated debt issuers

In this study we use a unique dataset to examine the effectiveness of hedging techniques in reducing currency risk across different time horizons. Our primary results indicate that issuers of foreign-denominated debt (FDD) effectively use foreign exchange derivatives (FXD) and geographic sales-to-asset alignment to reduce currency exposure. We measure currency exposure, over multiple return horizons, as the sensitivity of firm’s stock returns to changes in the exchange rate while controlling for market’s return. In particular, we find that the use of foreign exchange derivatives is effective in the short-term horizon and the geographic sales-to-asset alignment is effective in the intermediate and longer-term horizons. When we control for foreign sales and for firm size, the primary results are robust. Our study contributes to the literature by providing evidence of the time period when the use foreign exchange derivatives and the geographic sales-to-asset alignment is most effective for issuers of foreign-denominated debt.     

AN EMPIRICAL STUDY OF THE DIFFUSION PROCESS OF SECURITIES AND PORTFOLIOS

The nature of the stochastic process generating the path of security prices through time plays an important role in dynamic theories of financial economics. An important consideration is the possible dependency of return variances on price levels. Using 55 years of data separated into five-year intervals, this study demonstrates that, in general, security and portfolio variances are dependent on stock price levels and the relationship is a function of portfolio size. The relationship is unstable over time. The results suggest possible detrimental effects of diversification and financial models based on log-normality are questionable.     

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.     

International Interest Rates,Exchange Rates,and the Stochastic Structure of Supply

In a dual-currency, flexible exchange rate model, both nominal and real foreign exchange premia depend on investor risk attitudes, consumption parameters, and the stochastic structure of currency and commodity supplies. When supplies are random, their joint correlation structure determines the sign of the premia. If the money supplies are identically distributed, then all foreign exchange premia, regardless of the currency of denomination, are zero. A positive correlation between the value of a country's currency and its nominal interest rate need not indicate real interest rate movements. Relative bond prices can be negatively correlated with the terms of trade.     

Simulated likelihood estimation of diffusions with an application to exchange rate dynamics in incomplete markets

We present an econometric method for estimating the parameters of a diffusion model from discretely sampled data. The estimator is transparent, adaptive, and inherits the asymptotic properties of the generally unattainable maximum likelihood estimator. We use this method to estimate a new continuous-time model of the joint dynamics of interest rates in two countries and the exchange rate between the two currencies. The model allows financial markets to be incomplete and specifies the degree of incompleteness as a stochastic process. Our empirical results offer several new insights into the dynamics of exchange rates.     

Foreign Exchange Exposure Elasticity and Financial Distress

Financially distressed firms have limited ability to manage exchange rate exposure over time which could cause their fundamental value to be sensitive to the cash flow volatility related to currency movements. Accordingly, we hypothesize that the likelihood and costs of financial distress help explain cross‐sectional variations in return sensitivity to currency movements. We find that the level of exchange rate exposure elasticity is related to proxies for the likelihood of financial distress, growth opportunities, and product uniqueness. Further, firms with a greater likelihood and higher costs of financial distress exhibit greater abnormal returns in response to large exchange rate shocks.     

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.     

PRICING CURRENCY OPTIONS UNDER STOCHASTIC INTEREST RATES AND JUMP‐DIFFUSION PROCESSES

We investigate the effects of stochastic interest rates and jumps in the spot exchange rate on the pricing of currency futures, forwards, and futures options. The proposed model extends Bates's model by allowing both the domestic and foreign interest rates to move around randomly, in a generalized Vasicek term‐structure framework. Numerical examples show that the model prices of European currency futures options are similar to those given by Bates's and Black's models in the absence of jumps and when the volatilities of the domestic and foreign interest rates and futures price are negligible. Changes in these volatilities affect the futures options prices. Bates's and Black's models underprice the European currency futures options in both the presence and the absence of jumps. The mispricing increases with the volatilities of interest rates and futures prices. JEL classification: G13     

Remittances and Currency Crisis: The Case of Developing and Emerging Countries

Employing the first-generation currency crisis model of Flood and Garber (1984), I explore the financial effects of migrants' remittances on the economies of developing and emerging countries in a currency crisis. The model implies that remittances can contribute to a reduction in the likelihood of a currency crisis and appreciation in foreign exchange rates via the promotion of foreign exchange reserves. Panel estimation with twelve developing and emerging countries that previously experienced financial crises confirms the implications, suggesting that migrants' remittances can play a significant role in mitigating financial constraints and thus contribute to financial stability.     

Income repatriation decision for multinational corporations: Tax issues

This paper analyzes the existing asymmetry in the US corporate tax law governing the determination of foreign tax credits earned by US firms with foreign subsidiaries. The existing asymmetry results in the US government de facto holding foreign currency put options against US firms with foreign subsidiaries. Combined with the exchange rate volatility, this tax law asymmetry reduces the effective foreign after-tax rate of return and, thus, makes it profitable for US firms to repatriate their foreign source income earlier even when the foreign after-tax rate of return is higher than the domestic rate. Although this paper identifies this asymmetry in the tax law and analyzes its potential effect on the timing of foreign source income repatriation, it is an open question as to the economic significance of this tax code feature provided the firms’ ability to curry the unused tax credit forward for up to 10 years.